Question

9. Each of the following factors affects the weighted average cost of capital (WACC) equation. Which are factors that a firm can control? Check all that apply.

The firm’s dividend payout ratio

Interest rates in the economy

Tax rates

The firm’s capital budgeting decision rules

The impact of cost of capital on managerial decisions

Consider the following case:

National Petroleum Refiners Corporation (NPR) has two divisions, L and H. Division L is the company’s low-risk division and would have a weighted average cost of capital of 8% if it was operated as an independent company. Division H is the company’s high-risk division and would have a weighted average cost of capital of 14% if it was operated as an independent company. Because the two divisions are the same size, the company has a composite weighted average cost of capital of 11%. Division H is considering a project with an expected return of 12%.

Should National Petroleum Refiners Corporation (NPR) accept or reject the project?

Reject the project

Accept the project

On what grounds do you base your accept–reject decision?

Division H’s project should be accepted, as its return is greater than the risk-based cost of capital for the division.

Division H’s project should be rejected since its return is less than the risk-based cost of capital for the division.

2. 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 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 40%, 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: Do not round your intermediate calculations.)

1.07%

0.96%

1.28%

1.44%

Turnbull Co. is considering a project that requires an initial investment of $570,000. The firm will raise the $570,000 in capital by issuing $230,000 of debt at a before-tax cost of 9.6%, $20,000 of preferred stock at a cost of 10.7%, and $320,000 of equity at a cost of 13.5%. 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 $45 million. It has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. Kuhn has noncallable bonds outstanding that mature in five years with a face value of $1,000, an annual coupon rate of 10%, and a market price of $1,050.76. 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 shares of preferred stock that pay an annual dividend of $9 at a price of $95.70 per share. You can assume that Jordan does not incur any flotation costs when issuing debt and preferred stock.

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 $1.36 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 a constant rate of 9.2%, and they face a tax rate of 40%.

Determine what Kuhn Company’s WACC will be for this project.

Answer 1