Question

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, If its current tax rate is 40%, how much higher will 6% preferred stock, and 36% common equity. It has a Turnbull's weighted average cost of capital (WACC) be if before-tax cost of debt of 8.2%, and its cost of preferred it has to raise additional common equity capital by stock is 9.3%. issuing new common stock instead of raising the funds through retained earnings? If Turnbull can raise all of its equity capital from retained 0.54% earnings, its cost of common equity will be 12.4%. O 0.58% However, if it is necessary to raise new common equity, 0.64% it will carry a cost of 14.2%. O 0.86% Turnbull Co. is considering a project that requires an initial investment of $270,000. The firm will raise the $270,000 in capital by issuing $100,000 of debt at a before-tax cost of 10.2%, $30,000 of preferred stock at a cost of 11.4%, and $140,000 of equity at a cost of 14.3%. 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 $4 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 $1.36 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 8.7%, and they face a tax rate of 40%. Determine what Kuhn Company's WACC will be for this project.

Answer 1

Answer 1: 0.64%

A В 1 2 Weight of: 3 Debt 58% 4 Preferred Stock 5 Common Stock 6% 36% 6 7 Cost of: 8 Debt 9 Preferred Stock 8.20% 9.30% 10 Common Stock (retained earnings) 12.40% 11 Common Stock (new issuances) 14.20% 12 13 Tax Rate 40% 14 15 WACC (retained earnings) 7.88% 16 WACC (new issuance) 8.52% 17 Difference 0.65% 18

А В 1 2 Weight of: 3 Debt 0.58 4 Preferred Stock 5 Common Stock 0.06 0.36 6 7 Cost of: 8 Debt 9 Preferred Stock 10 Common Stock (retained earnings) 0.082 0.093 0.124 11 Common Stock (new issuances) 0.142 12 13 Tax Rate 0.4 14 15 WACC (retained earnings) 16 WACC (new issuance) (B3 B8*(1-B13))+(B4*B9)+(B5*B10) (B3 B8*(1-B13))+(B4*B9)+(B5*B11) 17 Difference -B16-B15 18.

Answer 2: 10.95%

В A 1 $270,000 2 Initial Investment 4 Weight of 5 Debt 37.04% 6 Preferred Stock 11.11% 7 Common Stock 51.85% 9 Cost of 10 Debt 10.20% 11 Preferred Stock 11.40% 12 Common Stock 14.30% 13 14 Tax Rate 40% 15 16 WACC 10.95% 17 Nm CO

A В 1 2 Initial Investment 270000 3 4 Weight of -100000/$B$2 5 Debt 6 Preferred Stock 7 Common Stock =30000/B2 -140000/B2 9 Cost of 10 Debt 0.102 11 Preferred Stock 0.114 12 Common Stock 0.143 13 14 Tax Rate 0.4 15 (B5*B10*(1-B14))+(B6*B11)+(B7* B12) 16 WACC 17

Answer 3: 8.32%

A В C D E F G 1 Cost of Debt 2 Cost of Common Equity We need to calculate YTM for this bond We need to use constant growth dividend discount 3 D1 +g r = РО issue, which is cost of debt model for this 4 5 Par Value 6 Coupon Rate 7 Market price 8 Years to Maturity 1000 Price of Common Stock 33.35 10% Floatation Cost 8% Price Net of Floatation Cost 1050.76 30.682 Growth Rate 8.70% 5 9 Dividend expected 1.36 10 YTM (Cost of Debt) 11 Tax rate Cost of Equity 8.70% 13.13% 40% 12 Post tax Cost of Debt 5.22% 13 Weight of Debt 58% 6% 14 Cost of Preferred Equity Weight of Preferred Equity Cost of Preferred Stock = Annual dividend/Current price 36% 15 Weight of Common Equity 16 17 Annual Dividend WACC 8.32% 18 Current Price 95.7 19 Cost of Preferred Stock 9.40% 20. LL

А В С D E 1 Cost of Common Equity 2 Cost of Debt 3 D1 We need to calculate YTM for this bond issue, which is cost of debt We need to use constant growth dividend discount model for this + g РО 4 5 Par Value 1000 Price of Common Stock 33.35 6 Coupon Rate 7 Market price 8 Years to Maturity Floatation Cost 0.08 0.1 Price Net of Floatation Cost E5* (1-E6) 1050.76 Growth Rate 0.087 5 Dividend expected 9 1.36 10 YTM (Cost of Debt) 11 Tax rate =RATE (B8,B6 B5, B7,B5) Cost of Equity = (E9/E7)+E8 0.4 3[1-B11)*в10 12 Post tax Cost of Debt 13 Weight of Debt 0.58 14 Cost of Preferred Equity Weight of Preferred Equity 0.06 15 Weight of Common Equity 0.36 Cost of Preferred Stock Annual dividend/Current price 16 17 Annual Dividend 18 Current Price =(B12*E13)+(B19*E14)+(E10* E15) WACC 95.7 -B17/B18 19 Cost of Preferred Stock 20