Question

7. Solving for the WACC А. Аа 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 8.2%, and its cost of preferred stock is 9.3%. its current tax rate is 10%, how much higher will Tumbull'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? O 1.10% O 1.24% O 0.92% 0 1.20% 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%. Tumbull Co. is considering a project that requires an initial investment of $1,708,000. The firm will raise the $1,708,000 in capital by issuing $750,000 of debt at a before tax cost of 8.7%, $78,000 of preferred stock at a cost of 9.9% and 5850,000 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. Kuhn Co. is considering a new project that will require an initial investment of $20 million. It has a target capital structure of 35% debt, 2% preferred stock, and 63% common equity, Kuhn has noncalable 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 it issues. The company can 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 it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 3% of the funds raised by issuing new common stock. The company is projected to grow at constant rate , and they face a tax rate of 40% Determine what Kuhn Company's WACC will be for this project.

Answer 1

Answer 1: 0.92%

45% 4% 51% 2 Weight of: 3 Debt 4 Preferred Stock 5 Common Stock 6 7 Cost of: 8 Debt 9 Preferred Stock 10 Common Stock (retained earnings) 11 Common Stock (new issuances) 12 13 Tax Rate 14 15 WACC (retained earnings) 16 WACC (new issuance) 17 Difference 18 8.20% 9.30% 12.40% 14.20% 40% 8.91% 9.83% 0.92%

1 2 Weight of: 3 Debt 4 Preferred Stock 5 Common Stock 0.45 0.04 0.51 7 Cost of: 8 Debt 9 Preferred Stock 10 Common Stock (retained earnings) 11 Common Stock (new issuances) 12 13 Tax Rate 0.082 0.093 0.124 0.142 0.4 14 15 WACC (retained earnings) 16 WACC (new issuance) 17 Difference =(B3*B8*(1-B13))+(B4*B9)+(B5*B10) =(B3*B8*(1-B13))+(B4*B9)+(B5*B11) =B16-B15

Answer 2: 9.545%

2 Initial Investment $1,708,000 43.91% 4.57% 51.52% 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 15 16 WACC 8.70% 9.90% 13.20% 40% 9.545% 17

1708000 2 Initial Investment 3 4 Weight of 5 Debt 6 Preferred Stock 7 Common Stock =750000/$B$2 =78000/B2 =880000/B2 8 0.087 0.099 0.132 9 Cost of 10 Debt 11 Preferred Stock 12 Common Stock 13 14 Tax Rate 15 16 WACC 17 18 0.4 =(B5*810*(1-B14))+(B6*B11)+(B7*B12)

Answer 3: 15.20%

A D1 r = + g 1 2 Cost of Debt 3 We need to calculate YTM for this 4 bond issue, which is cost of debt 5 Par Value 1000 6 Coupon Rate 11% 7 Market price 1555.38 8 Years to Maturity 9 10 YTM (Cost of Debt) 5.48% 11 Tax rate 40% 12 Post tax Cost of Del 3.29% 13 14 Cost of Preferred Equity 15 Cost of Preferred Stock = Annual 16 dividend/Current price 17 Annual Dividend 18 Current Price 92.25 19 Cost of Preferred S 8.67% Cost of Common Equity We need to use constant growth dividend discount model for this Price of Common Stock 22.35 Floatation Cost 3% Price Net of Floatation Cost 21.6795 Growth Rate 9.20% Dividend expected 2.78 Cost of Equity 22.02% 15 Weight of Debt Weight of Preferred Equity Weight of Common Equity 35% 2% 63% 8 WACC 15.20%

1 2 Cost of Debt 3 Cost of Common Equity We need to use constant growth dividend discount model for this 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 15 9 10 YTM (Cost of Debt) =RATE(B8,B6*B5,-B7,B5) 11 Tax rate 0.4 12 Post tax Cost of Debt =(1-B11)*B10 13 14 Cost of Preferred Equity 15 Cost of Preferred Stock = Annual dividend/Current price Price of Common Stock Floatation Cost Price Net of Floatation Cost Growth Rate Dividend expected Cost of Equity 22.35 0.03 =E5*(1-E6) 0.092 2.78 =(E9/E7)+E8 Weight of Debt Weight of Preferred Equity Weight of Common Equity 0.35 0.02 0.63 16 WACC =(B12*E13)+(B19*E14)+(E10*E15) 17 Annual Dividend 18 Current Price 19 Cost of Preferred Stock 20 92.25 =B17/18