2. Solving for the WACC

9.97

The WACC is used as the discount rate to evaluate variouscapital budgeting projects. However, it is important to realizethat the WACC is only an appropriate discount rate for a project ofaverage risk—in other words, a project that has the same beta asthe company. If a project has less risk than the overall companyrisk, it should be evaluated with a lower discount rate; if aproject is riskier than the overall company risk, it should beevaluated using a discount rate higher than the company WACC.

Analyze the cost of capital situations of the following companycases, and answer the specific questions that finance professionalsneed to address.

Consider the case of Turnbull Co.

Turnbull Co. has a target capital structure of 58% debt, 6%preferred stock, and 36% common equity. It has a before-tax cost ofdebt of 8.2%, and its cost of preferred stock is 9.3%.

If Turnbull can raise all of its equity capital from retainedearnings, its cost of common equity will be 12.4%. However, if itis necessary to raise new common equity, it will carry a cost of14.2%.

If its current tax rate is 40%, how much higher will Turnbull’sweighted average cost of capital (WACC) be if it has to raiseadditional common equity capital by issuing new common stockinstead of raising the funds through retained earnings? (Note: Donot round your intermediate calculations.)

0.65%

0.55%

0.88%

0.81%

Turnbull Co. is considering a project that requires an initialinvestment of $1,708,000. The firm will raise the $1,708,000 incapital by issuing $750,000 of debt at a before-tax cost of 9.6%,$78,000 of preferred stock at a cost of 10.7%, and $880,000 ofequity at a cost of 13.5%. The firm faces a tax rate of 40%. Whatwill be the WACC for this project? ______ (Note: Do not roundintermediate calculations.)

Consider the case of Kuhn Co.

Kuhn Co. is considering a new project that will require aninitial investment of $4 million. It has a target capital structureof 58% debt, 6% preferred stock, and 36% common equity. Kuhn hasnoncallable bonds outstanding that mature in five years with a facevalue of $1,000, an annual coupon rate of 10%, and a market priceof $1,050.76. The yield on the company’s current bonds is a goodapproximation of the yield on any new bonds that it issues. Thecompany can sell shares of preferred stock that pay an annualdividend of $8 at a price of $92.25 per share. You can assume thatJordan does not incur any flotation costs when issuing debt andpreferred stock.

Kuhn does not have any retained earnings available to financethis project, so the firm will have to issue new common stock tohelp fund it. Its common stock is currently selling for $33.35 pershare, and it is expected to pay a dividend of $2.78 at the end ofnext year. Flotation costs will represent 3% of the funds raised byissuing new common stock. The company is projected to grow at aconstant rate of 9.2%, and they face a tax rate of 40%. Determinewhat Kuhn Company’s WACC will be for this project_______.