Question

Consider the case of Purple Lemon Fruit Company The CFO of Purple Lemon Fruit Company is trying to determine the company's WACC. He has determined that the company's before-tax cost of debt is 8.70%. The company currently has $750,000 of debt, and the CFO believes that the book value of the company's debt is a good approximation for the market value of the company's debt. • The firm's cost of preferred stock is 9.90%, and the book value of preferred stock is $45,000. • Its cost of equity is 13.20%, and the company currently has $500,000 of common equity on its balance sheet. • The CFO has estimated that the firm's market value of preferred stock is $78,000, and the market value of its common equity is $880,000. If Purple Lemon is subject to a tax rate of 40%, Purple Lemon Fruit Company's WACC is 9.5452 8.11% 7.64% 10.98% Consider the case of Purple Panda Products Purple Panda Products is considering a new project that will require an initial investment of $45 million. It has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. Purple Panda 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 new shares of preferred stock that pay an annual dividend of $9 at a price of $95.70 per share. Assume that Purple Panda new preferred shares can be sold without incurring flotation costs. Purple Panda 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 $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 40%. Purple Panda's WACC for this project will be: 10.00% 10.50% 9.00% O 8.50%

Answer 1

Solution to the FIRST QUESTION

After Tax Cost of Debt = 5.22% [8.70% x (1 – 0.40)]

Cost of Preferred stock = 9.90%

Cost of equity = 13.20%

Weight of Debt = 0.4391 [$750,000 / $1,708,000]

Weight of Preferred Stock = 0.0457 [$78,000 / $1,708,000]

Weight of Equity = 0.5152 [$80,000 / $1,708,000]

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [5.22% x 0.4391] + [9.90% x 0.0457] + [13.20% x 0.5152]

= 2.2922% + 0.4521% + 6.8009%

= 9.5452%

“Hence, Purple Lemon Fruit Company’s WACC will be 9.5452%”