Question

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, if its current tax rate is 40%, how much higher will 4% preferred stock, and 51% common equity. It has a Turnbull's weighted average cost of capital (WACC) be if before-tax cost of debt of 8.2%, and its cost of preferred it has to raise additional common equity capital by stock is 9.3% issuing new common stock instead of raising the funds through retained earnings? If Turnbull can raise all of its equity capital from retained 01.06% earnings, its cost of common equity will be 12.4%. O 0.83% However, if it is necessary to raise new common equity, 01.24% it will carry a cost of 14.2%. O 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 8.7%, $30,000 of preferred stock at a cost of 9.9%, and $140,000 of equity at a cost of 13.2%. The firm faces a tax rate of 40%. What will be the WACC for this project? Consider the case of Kuhn Co.

Answer 1

		WACC, if Retained Earning is used
	Wd	Weight of debt	0.45
	Wp	Weight of Preferred stock	0.04
	Wc	Weight of common equity	0.51
	Cd	After tax Cost of debt =8.2*(1-Tax Rate)	4.92%	8.2*(1-0.4)
	Cp	Cost of preferred	9.30%
	Cc	Cost of equity	12.40%
		Weighted Average Cost of Capital (WACC)=Wd*Cd+Wp*Cp+Wc*Cc
		WACC=0.45*4.92+0.04*9.3+0.51*12.4=	8.91%
		IF New Common Stock is issued
	Cd	After tax Cost of debt =8.2*(1-Tax Rate)	4.92%
	Cp	Cost of preferred	9.30%
	Cc	Cost of equity	14.20%
		WACC=0.45*4.92+0.04*9.3+0.51*14.2=	9.83%
		Increase in WACC=9.83-8.91=	0.92%
		ANSWER: 0.92%
		New Project:
	a	Debt	$100,000
	b	Preferred stock	$30,000
	c	Equity	$140,000
	T	Total	$270,000
	Wd=a/T	Weight of Debt	0.37
	Wp=b/T	Weight of Preferred	0.11
	Wc=c/T	Weight of Equity	0.52
	Cd	After tax Cost of debt =8.7*(1-Tax Rate)	5.22%	8.7*(1-0.4)
	Cp	Cost of preferred	9.90%
	Cc	Cost of equity	13.20%
		WACC=Wd*Cd+Wp*Cp+Wc*Cc=	9.88%
		WACC for the project	9.88%