Question

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 address. Consider the case of Turnbull Co. Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 8.2%, and its cost of preferred stock is 9.3%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%. If its current tax rate is 25%, 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? (Note: Round your intermediate calculations to two decimal places.) O 0.81% O 0.88% O 0.65% O 0.85%

Answer 1

rate positively ..

ans 1
	Post tax cost of debt =8.2%*(1-25%)			6.150%
	using retained earning
	Source	Weight	Cost	Weight * cost
	Debt	58%	6.150%	3.56700%
	preferred stock	6%	9.30%	0.55800%
	retained earning	36%	12.40%	4.46400%
A		100%		8.58900%
	using Fresh issue
	Source	Weight	Cost	Weight * cost
	Debt	58%	6.150%	3.56700%
	preferred stock	6%	9.30%	0.55800%
	Fresh issue	36%	14.20%	5.11200%
B		100%		9.23700%
C=B-A	Therefore change in WACC =			0.65%
	Ans =			0.65%
ans 2
	After tax cost of debt =		9.6%*(1-25%)
			7.20%
	computation of WACC
	using Fresh issue
	Source	Value	weight	Cost	Weight * cost
	Debt	100000	37.04%	7.200%	2.67%
	preferred stock	30000	11.11%	10.70%	1.19%
	Equity	140000	51.85%	13.50%	7.00%
		270000	100.00%		10.86%
	ans =				10.86%
ans 3
	Computation of post tax cost of debt
	we have to use financial calculator to solve this
	put in calculator
	FV		1000
	PV		-1050.76
	PMT	1000*10%	100
	N		5
	Compute I		8.70%
	Post tax cost of debt = 8.7%*(1-25%)			6.53%
	Cost of preferred stock = Annual dividend/Price today
			9/95.7
			9.404%
	Cost of equity =	(Expected dividend next year/(issue price - flotation cost)) + Growth rate
			1.36/(22.35-22.35*8%)+8.7%
			15.31%
	computation of wACC
	Source	weight	Cost	Weight * cost
	Debt	45.00%	6.525%	2.94%
	preferred stock	4.00%	9.40%	0.38%
	Equity	51.00%	15.31%	7.81%
		100.00%		11.12%
	ans =			11.12%