Question

5. Solving for the WACC Aa Aa 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 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 all 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 0.90% 0 0.98% О 0.75% 0.94% Turnbull Co. is considering a project that requires an initial investment of $1,708,000. The firm will raise the $1,708,000 in capital by issuing $750,000 of debt at a before-tax cost of 11.1%, $78,000 of preferred stock at a cost of 12.2%, and $880,000 of equity at a cost of 14.7%. The firm faces a tax rate of 40%. what will be the WACC for this project? 9.40% 1 1 .06% 7.19% 7.74% Consider the case of Kuhn Co.

Answer 1

1. a) WACC with retained Earnings = Weight of Equity * Cost of Retained earnings+ Weight of Debt * Cost of Debt * (1-Tax Rate) + Weight of Preferred Stock * Cost of Preferred Stock = 36%* 14.7% + 58%*11.1%*(1-40%)+ 6%* 12.2% = 9.8868%

WACC with equity = Weight of Equity * Cost of Equity+ Weight of Debt * Cost of Debt * (1-Tax Rate) + Weight of Preferred Stock * Cost of Preferred Stock = 36%* 16.8% + 58%*11.1%*(1-40%)+ 6%* 12.2% = 10.6428%

Difference = 0.75%

b) WACC of Turnbull Co = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt * (1-Tax Rate) + Weight of Preferred Stock * Cost of Preferred Stock = 14.7%* 880,000/1708000 + 11.1%*(1-40%)*750,000/1708000 + 12.2% * 78000/1708000 = 11.06%