Question

Suppose that as a financial manager you have collected the following information on your company.

Before-tax cost of debt	6.5%
Tax rate	40%
Total long term debt	$400,000
Cost of preferred stock	7.25%
Total preferred stock	$50,000
Cost of common stock	11%
Total common stock	$500,000
Finance Utilized	$850,000

The firm is considering undertaking a project that costs $250,000 with an expected return of 13.5%. Not having enough existing capital, how would you recommend going about obtaining the additional funds? Use the current WACC in your analysis. Discuss how the current WACC will change based on the type of financing chosen.

Answer 1

WACC = (Cost of Debt)* (Weight of debt)*(1-Tax Rate)+(Cost of preferred stock)*(Weight of Preferred Stock)+ (Cost of Common Stock)*(Weight of Common Stock)

Weight of Debt = (Total debt)/(Total Debt+Total Preferred Stock+Total Common Stock)

Weight of Preferred Stock = (Total Preferred Stock)/(Total Debt+Total Preferred Stock+Total Common Stock)

Weight of Common Stock = (Total Common Stock)/(Total Debt+Total Preferred Stock+Total Common Stock)

Given

	Cost	Value	Weight	Tax Rate
Debt	6.50%	$400,000	42.11%	40%
Preferred Stock	7.25%	$50,000	5.26%
Common Stock	11%	$500,000	52.63%

WACC = 6.5%*(400,000/950,000)*(1-40%)+7.25%*(50,000/950,000)+11%*(500,000/950,000) = 7.8132%

Total Funds available = $950,000

Used Funds = $850,000

Available for usage = $950,000-$850,000 = $100,000

Required Funds for the new Project = $250,000

Additional Funds required = $250,000 - $100,000 = $150,000

Expected Return on the project = 13.5%

(A) Since Expected Return on the project is greater than the WACC of the company, the Project should be taken up by the company.

Debt is the cheapest form of funds available to raise(6.5%) when compared to the Preferred Stock of 7.25% and Common Stock of 11%.

(B) To fund the additional amount of $150,000 required, the firm should raise the funds by taking Long term Debt.

New WACC with an additional $150,000 raised through debt will be based on the following parameters

	Cost	Value	Weight	Tax Rate
Debt	6.50%	550,000.00	50.00%	40%
Preferred Stock	7.25%	50,000.00	4.55%
Common Stock	11%	500,000.00	45.45%

New WACC = 6.5%*(550,000/1,100,000)*(1-40%)+7.25%*(50,000/1,100,000)+11%*(500,000/1,100,000) = 7.2795%

--> Additionally if Preferred Stock is used, the WACC would depend on following paramters

	Cost	Value	Weight	Tax Rate
Debt	6.50%	4,00,000.00	36.36%	40%
Preferred Stock	7.25%	2,00,000.00	18.18%
Common Stock	11%	5,00,000.00	45.45%

WACC = 6.5%*(400,000/1,100,000)*(1-40%)+7.25%*(200,000/1,100,000)+11%*(500,000/1,100,000) = 7.7364%

--> If Common Stock is used, the WACC would depend on following paramters

	Cost	Value	Weight	Tax Rate
Debt	6.50%	4,00,000.00	36.36%	40%
Preferred Stock	7.25%	50,000.00	4.55%
Common Stock	11%	6,50,000.00	59.09%

WACC = 6.5%*(400,000/1,100,000)*(1-40%)+7.25%*(50,000/1,100,000)+11%*(650,000/1,100,000) = 8.2477%

From the above analysis, the WACC would change as follows with the three ways of funding the additional amount required :

Original WACC	7.8132%
Debt Funding	7.2795%
Preferred Stock Funding	7.7364%
Common Stock Funding	8.2477%

From the above analysis, we can say that Debt funding is the best way to source the required additional funds for the project.

But the company should also keep in mind that as the proportion(weight) of Debt increases, the cost of raising Debt will also increase and should see that in long-run the debt proportion is under control.