Ch. 10 Problems-The Cost of Capital Due on Now 9 at 11.59 PM MST The WACC is use
ID: 2782811 • Letter: C
Question
Ch. 10 Problems-The Cost of Capital Due on Now 9 at 11.59 PM MST 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 rateonly 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 noed to address. Consider the case of Turnbull Co Tumbul 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 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 camings? If Tunbull 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 o 1.24% 0.92% 00.83% 1.15% , carry a cost of 14.2%. Tumbul Co. is considering a project that requires an initial investment of $270,000·Thc firm will raise the $270,000 in capital by issuing $100,000 of debt at a before-tax cost of 9.6%, $30,000 of preferred stock at a cost of 10.7%, and $140,000 of equity at a cost of 13.5%. The fim faces a tax rate of 40%, what will be the WACC for this project? 11.88% 7.75% 10.33% 11.36% Consider the case of Kuhn Co Kuhn Co, is considering a new project that will require an initial inwestment of $45 million. It has a target capital structure of 58% debt,6% preferred stock, and 36% common equity. Kuhn has noncallable bonds outstanding that mature in 15 years with a face value or s 1,000, an annual coupon rate of 11%, and a market price of S 1,555.38. 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 nat have any retained eamings 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 S2.78 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.Explanation / Answer
WACC = wd*rd*(1 – T) + wp*rp + we*re
Turnbull Case:
From Common stock, WACC = wd*rd*(1 – T) + wp*rp + 0.51*14.2
From Retained earnings = WACC = wd*rd*(1 – T) + wp*rp + 0.51*12.4
WACC = 0.51*(14.2 – 12.4) = 0.918% or 0.92%
Raising fund through new equity costs 0.92% higher than raising fund through retained earnings.
Before-tax cost of debt = 9.6%
After-tax cost of debt = 9.6*(1 – 0.4) = 9.6*0.6 = 5.76%
WACC = 10.32%
Capital Weight (w) Cost (%) Weight*Cost Debt 100,000 0.3704 5.76% 2.13% Preferred Stock 30,000 0.1111 10.70% 1.19% Common Stock 140,000 0.5185 13.50% 7.00% SUM = 270,000 1.0000 10.32%