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.)

0.65%

0.59%

0.75%

0.78%

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 11.1%, $30,000 of preferred stock at a cost of 12.2%, and $140,000 of equity at a cost of 14.7%. The firm faces a tax rate of 25%. What will be the WACC for this project? _____________ (Note: Round your intermediate calculations to three decimal places.)

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 $92.25 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 $22.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 3% 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 25%. What will be the WACC for this project? _________________(Note: Round your intermediate calculations to two decimal places.)

Answer 1

Answer 1: 0.65%

A B 1 2 Weight of: 3 Debt 58% 4 Preferred Stock 6% 5 Common Stock 36% 6 7 Cost of: 8 Debt 8.20% 9 Preferred Stock 9.30% 10 Common Stock (retained earnings) 12.40% 11 Common Stock (new issuances) 14.20% 12 13 Tax Rate 25% 14 15 WACC (retained earnings) 16 WACC (new issuance) 8.59% 9.24% 17 Difference 0.65% 18

A B 1 2 Weight of 3 Debt 0.58 4 Preferred Stock 0.06 5 Common Stock 0.36 6 7 Cost of 8 Debt 9 Preferred Stock 0.082 0.093 10 Common Stock (retained earnings) 0.124 11 Common Stock (new issuances) 0.142 12 13 Tax Rate 0.25 14 (B3* B8* (1-B13))+(B4*B9)+(B5*B10) (B3 B8*(1-B13))+(B4*B9)+(B5*B11) 15 WACC (retained earnings) 16 WACC (new issuance) 17 Difference -B16-B15 18 19

Question 2: Answer is 12.06%

A В 1 $270,000 2 Initial Investment 3 4 Weight of 5 Debt 37.04% 6 Preferred Stock 11.11% 7 Common Stock 51.85% 9 Cost of 10 Debt 11.10% 11 Preferred Stock 12.20% 12 Common Stock 14.70% 13 14 Tax Rate 25% 15 16 WACC 12.06% 17

А 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 11 Preferred Stock 12 Common Stock 0.111 0.122 0.147 13 14 Tax Rate 0.25 15 16 WACC =(B5 B10*(1-B14))+(B6* B11)+(B7* B12) 17 18.

Question 3: Answer is 12.30%

А В с D E F 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 D1 + g r = issue, which is cost of debt model for this 4 РО 5 Par Value 6 Coupon Rate 7 Market price 8 Years to Maturity Price of Common Stock 1000 22.35 10% Floatation Cost 3% Price Net of Floatation Cost 1050.76 21.6795 9.20% Growth Rate 5 9 Dividend ected 2.78 10 YTM (Cost of Debt) 11 Tax rate Cost of Equity 8.70% 22.02% 25% 12 Post tax Cost of Debt 6.53% Weight of Debt 13 58% 14 Cost of Preferred Equity Weight of Preferred Equity 6% Cost of Preferred Stock = Annual dividend/Current price 15 Weight of Common Equity 36% 16 17 Annual Dividend 18 Current Price 12.30% WACC 92.25 19 Cost of Preferred Stock 9.76% 20 LL

A В C D E 1 Cost of Common Equity 2 Cost of Debt We need to calculate YTM for this bond issue, which is 3 We need to use constant growth dividend discount model for this cost of debt 4 5 Par Value 6 Coupon Rate 7 Market price Price of Common Stock 1000 22.35 Floatation Cost 0.1 0.03 1050.76 Price Net of Floatation Cost =E5*(1-E6) Years to Maturity 8 Growth Rate 5 0.092 Dividend expected 9 2.78 10 YTM (Cost of Debt) Cost of Equity = (E9/E7)+E8 =RATE(B8,B6*B5,-B7,B5) 11 Tax rate 0.25 (1-B11) B10 12 Post tax Cost of Debt Weight of Debt 13 0.58 14 Cost of Preferred Equity Weight of Preferred Equity 0.06 15 Cost of Preferred Stock Annual dividend/Current price 16 Weight of Common Equity 0.36 17 Annual Dividend (B12 E13)+(B19*E14)+(E10* E15) WACC 9 18 Current Price 92.25 =B17/B18 19 Cost of Preferred Stock 20 21 22 23