Question

The weighted average cost of capital (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.

Consider the case of Turnbull Company.

Turnbull Company has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 8.20%, and its cost of preferred stock is 9.30%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.40%. However, if it is necessary to raise new common equity, it will carry a cost of 14.20%.

1.) If its current tax rate is 40%, Turnbull’s weighted average cost of capital (WACC) will be __________ (0.64%, 0.54%, 0.8%, 0.83%) higher if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings.

2.) Turnbull Company is considering a project that requires an initial investment of $1,708,000.00. The firm will raise the $1,708,000.00 in capital by issuing $750,000.00 of debt at a before-tax cost of 8.70%, $78,000.00 of preferred stock at a cost of 9.90%, and $880,000.00 of equity at a cost of 13.20%. The firm faces a tax rate of 40%. The WACC for this project is __________ (9.55% 10.51%, 6.69%, 10.98%)

Consider the case of Kuhn Corporation.

Kuhn Corporation is considering a new project that will require an initial investment of $45,000,000. It has a target capital structure consisting 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 $8.00 at a price of $92.25 per share.

Kuhn Corporation 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 8.00% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 9.20%, and they face a tax rate of 40%.

3.) Kuhn Company’s WACC for this project will be __________ (8.89%, 10.46%, 12.55%, 12.03%)

Answer 1

1

WACC in case of cost of retained earnings

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8.2*(1-0.4)

= 4.92

Weight of equity = E/A

Weight of equity =

W(E)=0.36

Weight of debt = D/A

Weight of debt = 0.58

W(D)=0.58

Weight of preferred equity =1-D/A-E/A

Weight of preferred equity = =1-0.58 - 0.36

W(PE)=0.06

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=4.92*0.58+12.4*0.36+9.3*0.06

WACC% = 7.88

WACC in case of cost of new equity

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8.2*(1-0.4)

= 4.92

Weight of equity = E/A

Weight of equity =

W(E)=0.36

Weight of debt = D/A

Weight of debt = 0.58

W(D)=0.58

Weight of preferred equity =1-D/A-E/A

Weight of preferred equity = =1-0.58 - 0.36

W(PE)=0.06

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=4.92*0.58+14.2*0.36+9.3*0.06

WACC% = 8.52

difference

=8.52-7.88=0.64%

2

Total Asset value = Value of Debt + Value of Equity + Value of Preferred equity

=750000+880000+78000

=1708000

Weight of Debt = Value of Debt/Total Asset Value

= 750000/1708000

=0.4391

Weight of Equity = Value of Equity/Total Asset Value

= 880000/1708000

=0.5152

Weight of Preferred equity = Value of Preferred equity/Total Asset Value

= 78000/1708000

=0.0457

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 8.7*(1-0.4)

= 5.22

WACC=after tax cost of debt*W(D)+cost of equity*W(E)+Cost of preferred equity*W(PE)

WACC=5.22*0.4391+13.2*0.5152+9.9*0.0457

WACC% = 9.55

Please ask remaining parts separately, questions are unrelated. I have done one bonus