Question

6. 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 address. Consider the case of Turnbull Co. Turnbull Co. has a target capital structure of 589% 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.) 0.72% 0.65% O0.81 % 0.78 %

Answer 1

Question 1: 0.65%

A 1 2 Debt 58% 3 Preferred Stock 4 Common Stock 6% 36% 6 7 Before tax cost of debt 8.20% 8 Cost of preferred stock 9.30% 9 Cost of Common Equity (Retained earnings) 12.40% 10 Cost of Common Equity (New Stock Issue) 14.20% 11 12 Tax rate 25% 13 14 WACC with Retained Earnings 8.59% 9.24% 15 WACC with new common stock 16 17 Difference in WACC 0.65% 18 19

1 2 Debt 0.58 3 Preferred Stock 0.06 4 Common Stock 0.36 6 7 Before tax cost of debt 8 Cost of preferred stock 9 Cost of Common Equity (Retained earnings) 10 Cost of Common Equity (New Stock Issue) 0.082 0.093 0.124 0.142 11 12 Tax rate 0.25 13 14 WACC with Retained Earnings 15 WACC with new common stock (B2* B7* (1-B12))+(B3*B8)+(B4*B9) (B2* B7* (1-B12))+(B3*B8)+(B4*B10) 16 17 Difference in WACC -B15-B14 18

Question 2: 10.86%

A В 1 $270,000 2 Initial Investment 4 Weight of 5 Debt 37.04% 6 Preferred Stock 7 Common Stock 11.11% 51.85% 9 Cost of 10 Debt 9.60% 11 Preferred Stock 10.70% 12 Common Stock 13.50% 13 14 Tax Rate 25% 15 16 WACC 10.86% 17 Nm

А В 1 2 Initial Investment 270000 3 4 Weight of = 100000/$B$2 5 Debt 6 Preferred Stock -30000/B2 7 Common Stock = 140000/B2 8 9 Cost of 10 Debt 0.096 11 Preferred Stock 0.107 12 Common Stock 0.135 13 14 Tax Rate 0.25 15 =(B5* B10*(1-B14))+(B6* B11)+(B7*B12) 16 WACC 17

Question 3: 11.27%

А В C D E F G 1 2 Cost of Debt Cost of Common Equity We need to calculate YTM for this bond We need to use constant growth dividend discount 3 D1 + g r = model for this issue, which is cost of debt 4 РО 5 Par Value 6 Coupon Rate 7 Market price 8 Years to Maturity Price of Common Stock 1000 22.35 11% Floatation Cost 8% Price Net of Floatation Cost 1555.38 20.562 Growth Rate 8.70% 15 Dividend exp 9 cted 1.36 10 YTM (Cost of Debt) 11 Таx rate Cost of Equity 5.48% 15.31% 25% 12 Post tax Cost of Debt 4.11% 13 Weight of Debt 35% 14 Cost of Preferred Equity Weight of Preferred Equity 2% Cost of Preferred Stock = Annual dividend/Current price 15 Weight of Common Equity 63% 16 17 Annual Dividend 18 Current Price 11.27% 9 WACC 95.7 19 Cost of Preferred Stock 9.40% 20 21 73 LL

A В C E 1 Cost of Common Equity 2 Cost of Debt We need to calculate YTM for this bond issue, which is We need to use constant growth dividend discount model for this cost of debt 4 5 Par Value Price of Common Stock 1000 22.35 6 Coupon Rate 7 Market price Floatation Cost 0.11 0.08 E5*(1-E6) 1555.38 Price Net of Floatation Cost 8 Years to Maturity Growth Rate 15 0.087 Dividend expected 9 1.36 10 YTM (Cost of Debt) =RATE (B8,B6* B5,-B7,B5) Cost of Equity =(E9/E7)+E8 11 Tax rate 0.25 (1-B11) B10 12 Post tax Cost of Debt Weight of Debt Weight of Preferred Equity Weight of Common Equity 13 0.35 14 Cost of Preferred Equity 0.02 15 Cost of Preferred Stock Annual dividend/Current price 16 0.63 (B12*E13)+(B19*E14)+ (E10* E15) 17 Annual Dividend 18 Current Price WACC 95.7 =B17/B18 19 Cost of Preferred Stock 20