Question

A firm’s weighted average cost of capital (WACC) is used as the discount rate to evaluate various capital budgeting projects. However, remember 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 Fuzzy Button Clothing Company

Fuzzy Button Clothing Company has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%.

If Fuzzy Button 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 Fuzzy Button’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 answer to two decimal places.)

0.83%

0.98%

0.75%

1.01%

Consider the case of Peaceful Book Binding Company

he CFO of Peaceful Book Binding Company is trying to determine the company’s WACC. He has determined that the company’s before-tax cost of debt is 9.60%. The company currently has $750,000 of debt, and the CFO believes that the book value of the company’s debt is a good approximation for the market value of the company’s debt.

•	The firm’s cost of preferred stock is 10.70%, and the book value of preferred stock is $45,000.
•	Its cost of equity is 13.50%, and the company currently has $500,000 of common equity on its balance sheet.
•	The CFO has estimated that the firm’s market value of preferred stock is $78,000, and the market value of its common equity is $880,000.

If PBBC is subject to a tax rate of 40%, Peaceful Book Binding Company’s WACC is ______.

Consider the case of Chilly Moose Fruit Producer

Chilly Moose Fruit Producer 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. Chilly Moose Fruit 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 it issues. The company can sell new shares of preferred stock that pay an annual dividend of $8 at a price of $95.70 per share. Assume that Chilly Moose Fruit new preferred shares can be sold without incurring flotation costs.

Chilly Moose Fruit 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 8% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.7%, and they face a tax rate of 40%.

Chilly Moose Fruit’s WACC for this project will be: (Note: Round your answer to two decimal places.)

18.38%

15.32%

12.26%

14.55%

Answer 1

WACC = K_d * w_d + K_p*w_p + K_e*w_e

K_{d =} cost of debt after tax

w_d = weight of debt

K_p = cost of preferred stock

w_p = weight of preferred stock

Ke = cost of equity

w_e = weight of equity

Fuzzy button clothing company

Weights:

Debt = 0.58

Preferred stock = 0.06

Equity = 0.36

before tax cost of debt = 11.1%

After tax cost of debt = 11.1(1-0.4) = 6.66%

cost of preferred stock = 12.2%

cost of equity if raised from retained earnings = 14.7%

cost of equity if raised from new common stock = 16.8%

WACC if equity capital is raised from retained earnings = 6.66%*0.58 + 12.2%*0.06 +14.7%*0.36

= 9.89%

WACC if equity capital is raised from common stock = 6.66%*0.58 + 12.2%*0.06 +16.8%*0.36

= 10.64%

Increase in WACC = 10.64% - 9.89% = 0.75%

Peaceful book binding company

Calculation of weights

Particulars	Market value	weight
Debt	$7,50,000	7,50,000/17,08,000 = 0.44
Preferred stock	$78,000	78,000/17,08,000 = 0.05
Equity	$8,80,000	8,80,000/17,08,000 = 0.51
Total	$ 17,08,000	1.00

Cost of debt after tax = 9.6(1-0.4) = 5.76%

WACC = 5.76%*0.44 + 10.7%*0.05 + 13.5%*0.51

= 9.95%

Chilly moose fruit producer

Weights:

Debt = 0.35

Preferred stock = 0.02

Equity = 0.63

Calculation of yield of bond using trial and error method:

Period	cash flow	df @5%	dcf	df @6%	dcf
1 - 15	110	10.379	1141.76	9.712	1068.35
15	1000	0.481	481	0.417	417
Total			1622.76		1485.35

Yield using interpolation = 5% + [(6-5) * (1622.76-1555.38)/(1622.76-1485.35)]

= 5% + 0.49% = 5.4%

cost of preferred stock = dividend / price = 8/95.70 = 8.36%

cost of equity = (next dividend /price ) + growth

= (2.78/22.35) + 0.087 = 21.14%

WACC = 5.49%*0.35 + 8.36%*0.02 + 21.14%*0.63 = 15.39%