7. Solving for the WACC The WACC is used as the discount rate to evaluate variou

Question

7. Solving for the WACC The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the wACC is an appropriate discount rate only for a project of average risk Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to addre ss Consider the case of Turnbull Co Turnbull Co. has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If its current tax rate is 40%, how much higher will Turnbull's weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? If Turnbull can raise al of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity it will carry a cost of 16.8%. 0.96% 1.07% O 1.34% O 1.23% Turnbull Co. is considering a project that requires an initial investment of $570,000. The firm will raise the $570,000 in capital by issuing $230,000 of debt at a before-tax cost of 11.1%, $20,000 of preferred stock at a cost of 12.2%, and $320,000 of equity at a cost of 14.7%. The firm faces a tax rate of 40%. What will be the WACC for this project? Consider the case of Kuhn Co Kuhn Co. is considering a new project that will require an initial investment of $20 million. It has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. Kuhn has noncallable bonds outstanding that mature in five years with a face value of $1,000, an annual coupon rate of 10%, and a market price of $1,050.76 The yield on the company's current bonds is a good approximation of the yield on any new bonds that it issues. The company can sell shares of preferred stock that pay an annual dividend of $9 at a price of $95.70 per share Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 8% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 9.2%, and they face a tax rate of 40%. Determine what Kuhn Company's WACC will be for this project.

Explanation / Answer

a) Change in WACC = weight of equity x Change in cost of equity = 51% x (16.8% - 14.7%) = 1.07%

b) WACC = wd x kd x (1 - tax) + wps x kps + we x ke

Here, wd - weight of debt = 230,000 / 570,000 = 40.35%, kd - cost of debt = 11.1%, tax = 40%, wps - weight of preferred stock = 20,000 / 570,000 = 3.5%, kps - cost of preferred stock = 12.2%, we - weight of equity = 230,000 /570,000 = 56.14%, ke - cost of equity = 14.7%

=> WACC = 40.35% x 11.1% x (1 - 40%) + 3.5% x 12.2% + 56.14% x 14.7% = 11.37%

c) Here, wd = 58%, wps = 6%, we = 36%

Cost of debt can be calculated using I/Y function on a calculator

N = 5, PMT = 10% x 1000 = 100, PV = -1050.76, FV = 1000 => Compute I/Y = 8.70% = kd

kps = Dividend / Price = 9 / 95.70 = 9.40%

Cost of equity, ke = D1 / (P x (1 - f)) + g = 2.78 / (33.35 x (1 - 8%)) + 9.2% = 18.26%

WACC = wd x kd x (1 - tax) + wps x kps + we x ke

= 58% x 8.70% x (1 - 40%) + 9.40% x 6% + 36% x 18.26%

= 10.17%

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