Question

please complete all parts to the 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 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 8.2%, and its cost of preferred stock is 9.3%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%. If its current tax rate is 25%, 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.) 0.72% 0.65% 0.81% 0.78%

Answer 1

Question 1: 0.65%

58% 1 2 Debt 3 Preferred Stock 4. Common Stock 6% 36% 6 7 Before tax cost of debt 8 Cost of preferred stock 9 Cost of Common Equity (Retained earnings) 10 Cost of Common Equity (New Stock Issue) 11 12 Tax rate 8.20% 9.30% 12.40% 14.20% 25% 13 14 WACC with Retained Earnings 15 WACC with new common stock 8.59% 9.24% 17 Difference in WACC 0.65% 18 19

1 2 Debt 3 Preferred Stock 4. Common Stock 5 0.58 0.06 0.36 0.082 0.093 0.124 0.142 7 Before tax cost of debt 8 Cost of preferred stock 9 Cost of Common Equity (Retained earnings) 10 Cost of Common Equity (New Stock Issue) 11 12 Tax rate 13 14 WACC with Retained Earnings 15 WACC with new common stock 16 17 Difference in WACC 0.25 =(B2*B7*(1-B12))+(B3*B8)+(B4*B9) =(B2*B7*(1-B12))+(83*B8)+(B4*B10) =B15-B14 18

Question 2: 10.86%

$270,000 1 A 1 2 Initial Investment 3 4 Weight of 5 Debt 6 Preferred Stock 7 Common Stock 8 9 Cost of 10 Debt 11 Preferred Stock 12 Common Stock 13 14 Tax Rate 37.04% 11.11% 51.85% 9.60% 10.70% 13.50% 25% 16 WACC 10.86%

А 1 270000 2 Initial Investment 3 4 Weight of 5 Debt 6 Preferred Stock 7 Common Stock =100000/$B$2 =30000/B2 =140000/B2 9 Cost of 10 Debt 11 Preferred Stock 12 Common Stock 13 14 Tax Rate 0.096 0.107 0.135 0.25 15 =(B5*B10*(1-B14))+(B6*B11)+(B7*B12) 16 WACC 17

Question 3: 11.27%

B C D1 P= Po + 9 Cost of Common Equity We need to use constant growth dividend discount model for this Price of Common Stock 22.35 Floatation Cost Price Net of Floatation Cost 20.562 Growth Rate 8.70% Dividend expected 1.36 Cost of Equity 15.31% 8% 2 Cost of Debt 3 We need to calculate YTM for this bond issue, which is cost of debt 5 Par Value 1000 6 Coupon Rate 11% 7 Market price 1555.38 8 Years to Maturity 15 9 10 YTM (Cost of Debt) 5.48% 11 Tax rate 25% 12 Post tax Cost of Debt 4.11% 13 14 Cost of Preferred Equity 15 Cost of Preferred Stock = Annual 16 dividend/Current price 17 Annual Dividend 9 18 Current Price 95.7 19 Cost of Preferred Stock 9.40% Weight of Debt Weight of Preferred Equity Weight of Common Equity 35% 2% 63% WACC 11.27% 20

Cost of Common Equity We need to use constant growth dividend discount model for this 1 2 Cost of Debt 3 We need to calculate YTM for this bond issue, which is cost of debt 5 Par Value 1000 6 Coupon Rate 0.11 7 Market price 1555.38 8 Years to Maturity 9 10 YTM (Cost of Debt) =RATE(B8,B6*B5,-B7,B5) 11 Tax rate 0.25 12 Post tax Cost of Debt =(1-B11)*B10 13 14 Cost of Preferred Equity Price of Common Stock Floatation Cost Price Net of Floatation Cost Growth Rate Dividend expected Cost of Equity 22.35 0.08 =E5*(1-E6) 0.087 1.36 =(E9/E7)+E8 15 0.35 Weight of Debt Weight of Preferred Equity Weight of Common Equity 0.02 0.63 Cost of Preferred Stock = Annual dividend/Current price 16 WACC =(B12*E13)+(B19*E14)+(E10*E15) 17 Annual Dividend 18 Current Price 19 Cost of Preferred Stock 95.7 =B17/B18 20