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 11.1%, and its cost of preferred stock is 12.2%. If Turnbull 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 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.)

0.91%

0.99%

0.76%

0.68%

Answer 1

Solution to QUESTION-6

Weighted Average Cost of Capital (WACC) if Turnbull raises all equity from retained earnings (Cost of Equity = 14.70%)

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [11.10%(1 – 0.25) x 0.58] + [12.20% x 0.06] + [14.70% x 0.36]

= [8.33% x 0.58] + [12.20% x 0.06] + [14.70% x 0.36]

= 4.83% + 0.73% + 5.29%

= 10.85%

Weighted Average Cost of Capital (WACC) if Turnbull raises all equity from by issuing new shares (Cost of Equity = 16.80%)

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= [11.10%(1 – 0.25) x 0.58] + [12.20% x 0.06] + [16.80% x 0.36]

= [8.33% x 0.58] + [12.20% x 0.06] + [16.80% x 0.36]

= 4.83% + 0.73% + 6.05%

= 11.61%

Therefore, Turnbull’s Weighted Average Cost of Capital (WACC) is higher by 0.76% (11.61% - 10.85%)

“Hence, the answer will be 0.76%”