Question

Turnbull Co. is considering a project that requires an initial investment of $270,000. The firm will raise the $270,000 in capital by issuing $100,000 of debt at a before-tax cost of 8.7%, $30,000 of preferred stock at a cost of 9.9%, and $140,000 of equity at a cost of 13.2%. The firm faces a tax rate of 40%. What will be the WACC for this project?

9.88%

11.36%

10.87%

6.42%

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 35% debt, 2% preferred stock, and 63% 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 $92.25 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 $33.35 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 8.7%, and they face a tax rate of 40%. Determine what Kuhn Company’s WACC will be for this project.

8.12%

10.15%

11.67%

12.18%

Answer 1

Part a)

After tax cost of debt = before-tax cost of debt*(1-tax rate) = 8.7%*(1-0.4) = 8.7%*0.6 = 5.22%

WACC = [(After tax cost of debt*debt stock issued)+(cost of preferred stock*preferred stock issued)+(cost of equity*equity stock issued)]/Initial investment = [(5.22%*100000)+(9.9%*30,000)+(13.2%*130000)]/270000 = (5220+2970+17160)/270000 = 25350/270000 = 9.39%

Part b)

Calculation of cost of debt:

Year	Type	Cashflow	PVF @ 8.72%	Discounted cashflow = cashflow*PVF
1	Coupon	1000*10% = $100	1/1.0872 = 0.9198	$91.98
2	Coupon	1000*10% = $100	0.9198/1.0872 = 0.846	$84.60
3	Coupon	1000*10% = $100	0.846/1.0872 = 0.7781	$77.81
4	Coupon	1000*10% = $100	0.7781/1.0872 = 0.7157	$71.57
5	Coupon	1000*10% = $100	0.7157/1.0872 = 0.6583	$65.83
5	Maturity	$ 1,000	0.7157/1.0872 = 0.6583	$658.30
				$1,050.09

Current bond price is approximately equals to discounted cashflow, hence before tax cost of debt = 8.72%

After tax cost of debt = before tax cost of debt*(1-tax rate) = 8.72%*(1-0.4) = 8.72%*0.6 = 5.232%

Cost of preferred stock:

Cost of preferred stock = $9/$92.25 = 9.76%

Cost of equity:

Flotation cost = 3% on fund raised = $33.35*3% = $ 1

Cost of equity = [expected dividend/(stock price-flotation cost)]+growth rate = [$1.35/($33.35-$1)]+8.7% = ($1.35/$32.35)+8.7% = 4.17%+8.7% = 12.87%

WACC = (After tax cost of debt*35%)+(cost of preferred stock*2%)+(cost of equity*63%) = (5.232%*35%)+(9.78%*2%)+(12.87%*63%) = 1.8312%+0.1956%+8.1081% = 10.1349% = 10.14%