Question

15 . Solving for the WACC

The weighted average cost of capital (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.

Consider the case of Turnbull Company.

Turnbull Company has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.10%, and its cost of preferred stock is 12.20%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.70%. However, if it is necessary to raise new common equity, it will carry a cost of 16.80%.

If its current tax rate is 40%, Turnbull’s weighted average cost of capital (WACC) will be higher if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings.

Turnbull Company is considering a project that requires an initial investment of $1,708,000.00. The firm will raise the $1,708,000.00 in capital by issuing $750,000.00 of debt at a before-tax cost of 8.70%, $78,000.00 of preferred stock at a cost of 9.90%, and $880,000.00 of equity at a cost of 13.20%. The firm faces a tax rate of 40%. The WACC for this project is 9.55% .

Consider the case of Kuhn Corporation.

Kuhn Corporation is considering a new project that will require an initial investment of $4,000,000. It has a target capital structure consisting 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 $8.00 at a price of $95.70 per share.

Kuhn Corporation 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 $1.36 at the end of next year. Flotation costs will represent 8.00% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.70%, and they face a tax rate of 40%.

Kuhn Company’s WACC for this project will be?

Answer 1

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e 9 w a v ' . * 0427 ENG 28-02-202022 GS22 X - GS GY GZ HA HB ra 1 sum 2 ANS 1 NOTE 1 kd (AFTER TAX) kd = 11.1 (1-0.4) - 6.66% fic C GT GU GV GW GX turnbull WACC (COMMON EQUITY) c B*c SOURCE WEIGHT COC (%) WEIGHTED COST COMMON EQUITY 36% 14.70% 5.292% DEBT 58% 6.66% 3.863% PREFERRED STOCK 6% 12.20% 0.732% 100% WACC = 9.89% NOTE 2 kp =12.2 % GIVEN NOTE 3 COST OF COMMON EQUITY = 14.7% COST OF NEW COMMON EQUITY = 16.8% WACC (NEW COMMON EQUITY) CB*C SOURCE WEIGHT COC (%) WEIGHTED COST COMMON EQUITY 36% 16.80% 6.048% DEBT 58% 6.66% 3.863% PREFERRED STOCK 6% 12.20% 0.732% 100% WACC = 10.64% 19 INCREASE IN WACC = 10.64% -9.89%= 20 ANSWER : 0.75% 23 ... convexity DGM beta port future INDEX INTL CAP BUD SANDRINE LEASING PV, FV, ANNUITY DIR right clean YIELD bond portfolio WACC RESI DIVI... ►

Hee 9W v ' ** : ENG 04:30 28-02-2020 22 X GV506 X fix - GR GS GT GU GV GW GX GY GZ HA HB - 493 494 TURNBULL 495 496 497 WACC 498 NOTE 1 kd (AFTER TAX) kd = 8.70%(1-0.4) = AMOUNT 5.22% 499 500 501 502 503 SOURCE COMMON EQUITY DEBT PREFERRED STOCK WEIGHT 880000 51.52% 750000 43.91% 78000 4.57% 1708000 100% с COC (%) 13.20% 5.22% 9.90% в*с WEIGHTED COST 6.801% 2.292% 0.452% WACC = 9.55% 504 505 506 507 508 509 510 511 512 513 514 515 C16 ... CoNvexity DGM beta port future INDEX INTL CAP BUD SANDRINE LEASING PV, FV, ANNUITY DIR right clean YIELD bond portfolio WACC RESI DIVI....

w 2 v . * 04:33 ENG 28-02-2020 22 GQ611 fix GQ X GR KUHN GS GT GU GV GW GX GY GZ HA 591 592 593 BOND (kd) FV 594 PV 1000 1050.76 10% 595 596 COUPON LIFE kd (BEFORE TAX) Kd (AFTER TAX) 597 598 8.70% (=RATE(GT596,-GT595*GT593,GT594,-GT593)] 5.223% 8.70%(1-0.4) = 599 600 kp = D/PO = 8/95.70 = 8.359% 601 602 603 ke = 01/(PO(1-f) + g D1 = 1.36, g= 8.70%, f = 8%, PO = 33.35 604 605 ke = 1.36/(33.35(1-0.08)) + 0.087 13.133% 606 607 WACC (NEW COMMON EQUITY) 608 609 WEIGHT 610 SOURCE COMMON EQUITY DEBT PREFERRED STOCK 6111 B*C COC (%) WEIGHTED COST 13.133% 4.73% 5.223% 3.03% 8.359% 0.50% 36% 58% 6% 100% 612 613 614 ANSWER WACC = 8.26% ... convexity DGM beta port future INDEX INTL CAP BUD SANDRINE LEASING PV, FV, ANNUITY DIR right clean YIELD bond portfolio WACC RESI DIVI... ►