Question

6. Solving for the WACC

The 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.
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, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%.
If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%.
If its current tax rate is 40%, how much higher will Turnbull’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 intermediate calculations to two decimal places.)

   1.07%
   1.39%
   0.96%
   0.91%
Turnbull Co. is considering a project that requires an initial investment of $570,000. The firm will raise the $570,000 in capital by issuing $230,000 of debt at a before-tax cost of 10.2%, $20,000 of preferred stock at a cost of 11.4%, and $320,000 of equity at a cost of 14.3%. The firm faces a tax rate of 40%. What will be the WACC for this project? (Note: Round your intermediate calculations to three decimal places.)
Consider the case of Kuhn Co.
Kuhn Co. is considering a new project that will require an initial investment of $4 million. It has a target capital structure of 58% debt, 6% preferred stock, and 36% 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 $1555.38. 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 $95.70 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 $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% 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 will be the WACC for this project? (Note: Round your intermediate calculations to two decimal places.)

Answer 1

Higher WACC if it raises additional common equity capital by issuing new common stock instead of using retained earnings:

U A B 1 2 Target Capital Structure: 3 Debt 45% 4 Preferred Stock 4% 5 Common Equity 51% 6 Before tax cost of debt 11.10% Given in question 7 Cost of preferred stock 12.20% 8 Cost of common equity (retained earnings) 14.70% 9 Cost of new common equity 16.80% 10 Tax Rate 40% 11 After tax cost of debt 6.66% =B6*(1-B10) 12 13 Calculation of WACC 14 WACC = (After Tax Cost of Debt * Debt % of total capital)+(Cost of Preferred Stock * Preferred 15 Stock % of total capital)+(Cost of Common Equity * Common Equity % of total capital) 16 If retained earnings are used 10.98% =(B3*B11)+(B4*B7)+(B5*B8) 17 If new common equity is raised 12.05% =(B3*B11)+(B4*B7)+(B5*B9) 18 Higher WACC If new common equity is raised 1.07% =B17-B16 10

Thus, Higher WACC is new common equity is raised = 1.07% (1st option)

WACC for the project of Turnbull Co.:

A B C 20 21 Initial Investment $570,000 22 Debt Value $230,000 Given in question 23 Before Tax Cost of Debt 10.20% 24 Tax Rate 40% 25 After Tax Cost of Debt 6.12% =(B23*(1-B24)) 26 Preferred Stock Value $20,000 27 Cost of Preferred Stock 11.40% Given in question 28 Equity Stock Value $320,000 29 Cost of Equity Stock 14.30% 30 31 Calculation of WACC 32 WACC = (After Tax Cost of Debt * Debt % of total capital)+(Cost of Preferred Stock * Preferred Stock % 33 of total capital)+(Cost of Common Equity * Common Equity % of total capital) 34 Debt % of Total Investment 40.35% =B22/$B$21 35 Preferred Stock % of Total Investment 3.51% =B26/$B$21 36 Common Equity Stock % of Total Investment 56.14% =B28/$B$21 37 WACC 10.90% =(B34*B25)+(B35*B27)+(B36*B29) 38

WACC for the project of Turnbull Co. = 10.90%

WACC for this project of Kuhn Co.:

A B $4,000,000 58% 6% 36% 38 39 Initial Investment 40 Target Capital Structure: 41 Debt 42 Preferred Stock 43 Common Equity 44 Maturity of Bond (years) 45 Face Value 46 Annual Coupon Rate 47 Market Price 48 Annual Dividend of Preferred Stock 49 Market Price of Preferred Stock 50 Market Price of New Common Stock 51 Dividend next year 52 Floatation costs 53 Constant Growth Rate 54 Tax Rate 15 $1,000 11% $1,555.38 $8 $95.70 $33.35 $1.36 8% 9.20% 40%

A B C 55 56 Calculation of Yield to Maturity of Debt which is the cost of debt 57 Yield to Maturity (Before Tax) calculated using =rate(nper,pmt, pv,fv) 58 nper = period 15 =B44 59 pmt = Annual Coupon $110 =B45*346 60 pv = Market Price $1,555.38 =B47 61 fv = Face Value $1,000 =B45 62 Yield to Maturity (Before Tax) 5.48% =RATE(358,359,-B60,361) 63 Yield to Maturity (After Tax) 3.29% =B62*(1-854) 64 65 Calculation of Cost of Preferred Stock 66 Cost of Preferred Stock = Dividend / Market Price 67 Cost of Preferred Stock 8.36% =B48/B49 68 69 Calculation of Cost of New Common Stock 70 Cost of New Common Stock = (Dividend Next Year / (Market Price - Floatation costs))+Growth Rate 71 Cost of New Common Stock 13.63% =B51/(B50*(1-B52)) +353 72 73 Calculation of WACC 74 WACC = (After Tax Cost of Debt * Debt % of total capital)+(Cost of Preferred Stock * Preferred Stock % 75 of total capital)+(Cost of Common Equity * Common Equity % of total capital) 7.31% =(B63*341)+(B67*B42)+(371*B43) 76 WACC

WACC for this project of Kuhn Co. = 7.31%