Question

Kuhn Co. is considering a new project that will require an initial investment of $4 million. It has a target capital structure of 35% debt, 2% preferred stock, and 63% common equity. Kuhn has noncallable bonds outstanding that mature in five years with a par 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 at a price of $92.25 per share. Kuhn 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 $22.35 per share, and is expected to pay a dividend of $2.78 at the end of next year. Floatation 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%. What is the Kuhn Company's WACC for this project?

Answer 1

After-tax Cost of Debt

The After-tax Cost of Debt is the after-tax Yield to maturity of the Bond

The Yield to maturity of (YTM) of the Bond is calculated using financial calculator as follows (Normally, the YTM is calculated either using EXCEL Functions or by using Financial Calculator)

Variables	Financial Calculator Keys	Figure
Face Value [$1,000]	FV	1,000
Coupon Amount [$1,000 x 10%]	PMT	100
Yield to Maturity (YTM)	1/Y	?
Time to Maturity [5 Years]	N	5
Bond Price [-$1,050.76]	PV	-1,050.76

We need to set the above figures into the financial calculator to find out the Yield to Maturity of the Bond. After entering the above keys in the financial calculator, we get the yield to maturity (YTM) on the bond = 8.70%

After Tax Cost of Debt = Yield to maturity x (1 – Tax Rate)

= 8.70% x (1 – 0.40)

= 8.70% x 0.60

= 5.22%

Cost of Preferred Stock

Cost of Preferred Stock = Preferred Dividend / Selling Price of the Share

= [$8.00 / $92.25] x 100

= 8.67%

Cost of Common Stock

Dividend in year 1 (D1) = $2.78 per share

Current selling price per share (P0) = $22.35 per share

Dividend growth Rate (g) = 9.20% per year

Flotation Cost (FC) = 3.00%

Therefore, the Cost of Common Stock = [D1 / {P0(1 – FC)] + g

= [$2.78 / {$22.35 x (1 – 0.03)}] + 0.0920

= [$2.78 / $21.6795] + 0.0920

= 0.1282 + 0.0920

= 0.2202 or

= 22.02%

Weighted Average Cost of Capital (WACC)

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 0.35] + [8.67% x 0.02] + [22.02% x 0.63]

= 1.83% + 0.17% + 13.87%

= 15.87%

“Hence, the Kuhn Company’s WACC for this Project will be 15.87%”