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 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 8.2%, and its cost of preferred stock is 9.3%.

If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%.

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.)

1.06%

1.01%

0.92%

1.10%

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 11.1%, $20,000 of preferred stock at a cost of 12.2%, and $320,000 of equity at a cost of 14.7%. The firm faces a tax rate of 25%. What will be the WACC for this project?      (Note: Round your intermediate calculations to three decimal places.)

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 $8 at a price of $92.25 per share.

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 $2.78 at the end of next year. Flotation costs will represent 8% 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 25%. What will be the WACC for this project?      (Note: Round your intermediate calculations to two decimal places.)

Answer 1

1. How much higher will Turnbull’s weighted average cost of capital (WACC)

Capital structure:
Debt	45%
Preferred stock	4%
Common Equity	51%
Before tax cost of debt	8.20%
Cost of Preferred stock	9.30%
Cost of Common Equity (retained earnings)	12.40%
Cost of New Common Equity	14.20%
Tax rate	25%
After tax cost of debt (8.20 * (1-.25)	6.15%

Computation of WACC

WACC=(After tax cost of debt * Debt % of total capital)+(Cost of Preferred stock * Preferred stock % of total capital)+(Cost of Common Equity * Common Equity% of total capital)
If retained earnigs are used	9.46	(6.15*45%)+(9.30*4%)+(12.40*51%)
If new common equity is raised	10.38	(6.15*45%)+(9.30*4%)+(14.20*51%)
Higher WACC if new equity is raised	0.92	(10.38-9.46)

2. WACC for the project

Initial Investment	570,000
Debt value	230,000
Before tax cost of debt	11.10%
Tax rate	25%
After tax cost of debt (11.10 * (1-.25)	8.33%
Preferred stock value	20,000
Cost of Preferred stock	12.20%
Equity stock value	320,000
Cost of Equity stock	14.70%

Computation of WACC

WACC=(After tax cost of debt * Debt % of total capital)+(Cost of Preferred stock * Preferred stock % of total capital)+(Cost of Common Equity * Common Equity% of total capital)
Debt % of total capital	40.35%	(230,000 / 570,000)
Preferred stock % of total capital	3.51%	(20,000 / 570,000)
Common Equity % of total capital	56.14%	(320,000 / 570,000)
WACC	12.04%	(8.33*40.35%)+(12.20*3.51%)+(14.70*56.14%)