Question

8. Solving for a firm's WACC A firm's weighted average cost of capital (WACC) is used as the discount rate to evaluate various capital budgeting projects. However, remember 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 Green Caterpillar Garden Supplies Green Caterpillar Garden Supplies 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 Green Caterpillar 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 40%, how much higher will Green Caterpillar'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 answer to two decimal places.) O 0.58% O 0.64% O 0.80% O 0.83%

Answer 1

Question 1 (Green Caterpillar Garden Supplies): Answer: 0.64%

1 2 Weight of: 3 Debt 4. Preferred Stock 5 Common Stock 58% 6% 36% 6 7 Cost of: 8 Debt 9 Preferred Stock 10 Common Stock (retained earnings) 11 Common Stock (new issuances) 8.20% 9.30% 12.40% 14.20% 13 Tax Rate 40% 14 15 WACC (retained earnings) 16 WACC (new issuance) 17 Difference 7.88% 8.52% 0.65% 10

0.58 0.06 0.36 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 14 15 WACC (retained earnings) 16 WACC (new issuance) 17 Difference 18 19 0.082 0.093 0.124 0.142 0.4 =(B3*B8*(1-B13))+(B4*B9)+(B5*B10) =(B3*B8*(1-B13))+(B4*B9)+(B5*B11) =B16-B15

Question 2 (Purple Panda Products): Answer 11.06%

2 Initial Investment $1,708,000 + LDN 4 Weight of 5 Debt 6 Preferred Stock 7 Common Stock 43.91% 4.57% 51.52% 00 9 Cost of 10 Debt 11 Preferred Stock 12 Common Stock 11.10% 12.20% 14.70% 13 40% 14 Tax Rate 15 16 WACC 17 11.06%

А B 1 =750000+78000+880000 2 Initial Investment 3 4 Weight of 5 Debt 6 Preferred Stock 7 Common Stock =750000/$B$2 =78000/B2 =880000/B2 0.111 0.122 0.147 9 Cost of 10 Debt 11 Preferred Stock 12 Common Stock 13 14 Tax Rate 15 16 WACC 17 18 10 0.4 =(B5*810*(1-B14))+(B6*B11)+(B7*B12)

Question 3 (Purple Lemon Fruit Company): Answer: 12.89%

в с 1 11 r = PO 9 2 Cost of Debt Cost of Common Equity 3 We need to calculate YTM for this We need to use constant growth dividend discount 4 bond issue, which is cost of debt model for this 5 Par Value 1000 Price of Common Stock 33.35 6 Coupon Rate 10% Floatation Cost 3% 7 Market price 1050.76 Price Net of Floatation Cost 32.3495 8 Years to Maturity Growth Rate 8.70% Dividend expected 2.78 10 YTM (Cost of Debt) 8.70% Cost of Equity 17.29% 11 Tax rate 40% 12 Post tax Cost of Del 5.22% 13 Weight of Debt 14 Cost of Preferred Equity Weight of Preferred Equity 2% 15 Cost of Preferred Stock = Annual Weight of Common Equity 63% 16 dividend/Current price 17 Annual Dividend 8 WACC 12.89% 18 Current Price 95.7 19 Cost of Preferred St 8.36% 35%

2 Cost of Debt Cost of Common Equity We need to use constant growth dividend discount model for this P= Pog 33.35 We need to calculate YTM for this bond issue, which is cost of debt 4 5 Par Value 1000 6 Coupon Rate 0.1 7 Market price 1050.76 8 Years to Maturity 0.03 Price of Common Stock Floatation Cost Price Net of Floatation Cost Growth Rate Dividend expected Cost of Equity =E5*(1-E6) 0.087 2.78 =(E9/E7)+E8 11 Tax 10 YTM (Cost of Debt) Tax rate 12 Post tax Cost of Debt 13 14 Cost of Preferred Equity =RATE(B8,B6*B5,-B7,B5) 0.4 =(1-B11)*B10 0.35 Weight of Debt Weight of Preferred Equity Weight of Common Equity 15 0.02 0.63 WACC =(B12*E13)+(B19*E14)+(E10*E15) Cost of Preferred Stock = Annual dividend/Current price 16 17 Annual Dividend 18 Current Price 95.7 19 Cost of Preferred Stock =B17/18 20