Question

Warren INC. bases their cost of capital or WACC on a number of erroneous assumptions.Going by their current methodology, Warren’s wacc is:

Component	Weight	Cost (pre-tax)	Cost (after-tax)
Debt	45.8%	10.0%	6%
Preferred stock	6.1%	7.6%	7.6%
Common equity	48.1%	7.5%	7.5%
Wacc			6.82%

Compute/answer the following:

1.Look at the pre-tax cost of each component in the current wacc shown above. What is the problem with these three values? In other words, if you knew nothing about how Warren is computing its wacc, and were only shown those three values, what red flag should these numbers raise?

2.Provide a revised estimate of Warren’s wacc using methods revised weighted average cost of capital. Show all of your work in putting together your estimate of the wacc. Also, you will have to make choices, so where needed,describe the choices/assumptions that you made in estimating the wacc.

3. With the old wacc estimate above, and your new wacc estimate, describe the impact on (1) the value of the firm, (2) investment decisions, and (3) growth of using the new wacc as opposed to the original wacc.

4.Should Warren use the new wacc for all potential investments/projects? Why/why not?

Important things to consider:

Ignore the call feature on the bonds and ignore flotation costs.

Answer 1

(1) In this question, the cost of Debt is showing highr then cost of equity.
Equity holders will not accept return lower then debt, as they do not have a contratual obligation ti be repiad their capital.
If this is the case equity holders will issue debt and wil be happy to get return on the debt better. Hence, assumption of equity cost lower then debt is incorrect.

(2) Since cost of equity is to be higher than cost of Debt,
assume cost of Equity is higher by 2% then cost of Debt (Which is reasonable), then WACC will 9$.

(3) The cost structure of the firm has an important impact on valution. Higher the cost structure of the firm lower is the valution.
-The invetsor will like to invest in the NEW WACC structure.
- The NEW WACC realistically reflects the cost and will be able to invite more investors.

(4) Warren should use NEW WACC for all poltential investmnets or project, as this realistically reflects the cost.