Question

If Grounds Keeper has a required rate of return on its long-term debt of 9% (before taxes) and a required rate of return on its common stock (of 16%?, {not positive this is correct}), a tax rate of 40%, what is its weighted average cost of capital (WACC) for 2012? How could Grounds Keeper lower its WACC? (HINT: you will need to look at the balance sheet to determine the weight of debt to equity.

Grounds Keeper Consolidated Balance Sheets (Dollars in thousands) 2012 2011 Assets Current assets: Cash and cash equivalents 78,240 44,395 Receivables 399,891 340,062 Inventories 844,737 736,677 Total current assets 1,322,868 1,121,133 Fixed assets, net 1,244,384 889,613 Other long-term assets 1,048,537 1,187,141 Total assets 3,615,789 3,197,887 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable 309,222 319,465 Accruals 201,017 145,240 Notes payable 9,748 6,669 Total current liabilities 519987 471374 Long-term debt 834574 814298 Total liabilities 1,354,561 1,285,672 Stockholders’ equity: Common stock, $0.10 par value: 15,268 15,447 Additional paid-in capital 1,464,560 1,499,616 Retained earnings 781400 397152 Total stockholders’ equity 2,261,228 1,912,215 Total liabilities and stockholders’ equity 3,615,789 3,197,887   Grounds Keeper Consolidated Statements of Operations (Dollars in thousands except per share data) 2012 2011 Net sales 3,889,426 2,642,390 Cost of sales 2,589,799 1,746,274 Gross profit 1,299,627 896,116 Selling and operating expenses 481,493 348,696 General and administrative expenses 219,010 187,016 Operating income 599,124 360,404 Interest expense 22,983 57,657 Income before income taxes 576,141 302,747 Income tax expense 212,641 101,699 Net Income 363,500 201,048 Basic income per share: Average shares outstanding 154,933,948 146,214,860 Earnings per common share 2.35 1.38

Answer 1

Step 1: Calculate Weight of Debt and Equity

The weight of debt and equity is determined as below:

Weight of Debt = Value of Total Debt/(Value of Total Debt+Value of Total Equity) = 1,354,561/(1,354,561+2,261,228) = 37.46%

Weight of Equity = Value of Total Equity/(Value of Total Debt+Value of Total Equity) = 2,261,228/(1,354,561+2,261,228) = 62.54%

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Step 2: Calculate Weighted Average Cost of Capital

The value of weighted average cost of capital is calculated as follows:

Weighted Average Cost of Capital = Weight of Debt*Pre-Tax Cost of Debt*(1-Tax Rate) + Weight of Equity*Cost of Equity

Substituting values in the above formula, we get,

Weighted Average Cost of Capital = 37.46%*9%*(1-40%) + 62.54%*16% = 12.03%

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Grounds Keeper can lower its WACC by modfiying its capital structure or by reducing the cost of debt or equity. In the given case, the cost of equity is substantially high. Therefore, Grounds Keeper can try to borrow more debt at lower cost and reducing the proportion of equity accordingly. However, it should consider the fact that inclusion of more debt would mean higher financial risk.