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 45% debt, 4% preferred stock, and 51% 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.) 01.10% 1.06% O 0.78% 0.92% 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 25%. What will be the WACC for this project? (Note: Round your intermediate calculations to three decimal places.) Consider the case of Kuhn co

Answer 1

Question 1: Answer is 0.92%

45% 4% 51% 1 2 Weight of: 3 Debt 4 Preferred Stock 5 Common Stock 6 7 Cost of: 8 Debt 9 Preferred Stock 10 Common Stock (retained earnings) 11 Common Stock (new issuances) 12 13 Tax Rate 8.20% 9.30% 12.40% 14.20% 25% 14 15 WACC (retained earnings) 16 WACC (new issuance) 17 Difference 18 9.46% 10.38% 0.92%

А 1 2 Weight of: 3 Debt 4. Preferred Stock 5 Common Stock 0.45 0.04 0.51 6 7 Cost of: 8 Debt 0.082 9 Preferred Stock 0.093 10 Common Stock (retained earnings) 0.124 11 Common Stock (new issuances) 0.142 12 0.25 13 Tax Rate 14 15 WACC (retained earnings) 16 WACC (new issuance) 17 Difference =(B3*B8*(1-B13))+(B4*B9)+(B5*B10) =(B3*B8*(1-B13))+(B4*B9)+(B5*B11) =B16-B15 18

Question 2: Answer is 11.51%

$270,000 2 Initial Investment 3 4 Weight of 5 Debt 6 Preferred Stock 7 Common Stock 37.04% 11.11% 51.85% 8 10.20% 11.40% 14.30% 9 Cost of 10 Debt 11 Preferred Stock 12 Common Stock 13 14 Tax Rate 15 16 WACC 17 25% 11.51%

270000 2 Initial Investment 3 4 Weight of 5 Debt 6 Preferred Stock 7 Common Stock =100000/$B$2 =30000/B2 =140000/B2 8 9 Cost of 10 Debt 11 Preferred Stock 12 Common Stock 0.102 0.114 0.143 13 14 Tax Rate 0.25 =(B5*B10*(1-B14))+(B6*B11)+(B7*B12) 16 WACC 17 18

Question 3: Answer is 9.88%

8% 15 9 в со 1 2 Cost of Debt Cost of Common Equity 3 We need to calculate YTM for this bond We need to use constant growth dividend discount 4 issue, which is cost of debt model for this 5 Par Value 1000 Price of Common Stock 33.35 6 Coupon Rate 11% Floatation Cost 7 Market price 1555.38 Price Net of Floatation Cost 30.682 8 Years to Maturity Growth Rate 8.70% Dividend expected 1.36 10 YTM (Cost of Debt) 5.48% Cost of Equity 13.13% 11 Tax rate 25% 12 Post tax Cost of Debt 4.11% 13 Weight of Debt 35% 14 Cost of Preferred Equity Weight of Preferred Equity 2% 15 Cost of Preferred Stock = Annual Weight of Common Equity 63% dividend/Current price 17 Annual Dividend 8 WACC 9.88% 18 Current Price 92.25 19 Cost of Preferred Stock 8.67% 16

1 Cost of Common Equity 2 Cost of Debt 3 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 Price of Common Stock Floatation Cost Price Net of Floatation Cost Growth Rate Dividend expected Cost of Equity 33.35 0.08 =E5*(1-E6) 0.087 1.36 =(E9/E7)+E8 5 Par Value 1000 6 Coupon Rate 0.11 7 Market price 1555.38 8 Years to Maturity 15 9 10 YTM (Cost of Debt) =RATE(B8,B6*B5,-B7,B5) 11 Tax rate 0.25 12 Post tax Cost of Debt =(1-B11)*B10 13 14 Cost of Preferred Equity 15 Cost of Preferred Stock = Annual dividend/Current price 16 17 Annual Dividend 18 Current Price 92.25 19 Cost of Preferred Stock =B17/B18 Weight of Debt Weight of Preferred Equity Weight of Common Equity 0.35 0.02 0.63 WACC =(B12*E13)+(B19*E14)+(E10*E15) 20 22