Question

7. 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 45% debt, 4% preferred stock, and 51% 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%. higher if it has to raise additional common equity If its current tax rate is 40%, Turnbull's weighted average cost of capital (WACC) will be 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 $270,000.00. The firm will raise the $270,000.00 in capital by issuing $100,000.00 of debt at a before-tax cost of 11.10%, $30,000.00 of preferred stock at a cost of 12.20%, and $140,000.00 of equity at a cost of 14.70%. The firm faces a tax rate of 40%. The WACC for this project is Consider the case of Kuhn Corporation. Kuhn Corporation is considering a new project that will require an initial investment of $20,000,000. It has a target capital structure consisting of 35% debt, 2% preferred stock, and 63% common equity. Kuhn has noncallable bonds outstanding that mature in 15 years with a face value of $1,000, an annual coupon rate of 11%, and a market price of $1,555.38. The yield on the company's current bonds is a good approximation of the yield on any new bonds that issues. The company can sell shares of preferred stock that pay an annual dividend of $9.00 at a price of $92.25 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 $2.78 at the end of next year. Flotation costs will represent 3.00% 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

D4 . =+C4/$C$11 A B E F G 1.07% -16.8%-14.7%)*51% WACC (Cost %xWeights) 7.622% 1 Issuing new common stocks will increase raise the WACC 2 Market Market value 3 Cost % value weights 4 Common stock 14.70% $ 140,000 0.5185 5 6 Debt (After tax cost) 6.66% $ 100,000 0.3704 7 =11.1%*(1-40%) 8 9 Preferred stock 12.20% $ 30,000 0.1111 10 11 Total $ 270,000 1.0000 12 2.467% 1.356% 13 Turnbull WACC 11.44% 14 Market value 15 Cost % Market value weights 0.6300 WACC (Cost %xWeights) 10.89% 63 17.29% $ =2.78/(33.35*(1-3%))+8.7% 35 0.3500 1.15% 3.29% $ =RATE(15,110,-1555.38,1000)*(1-40%) 16 Common stock 17 18 19 Debt (After tax cost) 20 21 22 Preferred stock 23 24 25 26 2 0.0200 0.20% 9.76% $ =9/92.25 Total $ 100 1.0000 27 Kuhn WACC 12.24%

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