6. Solving for the WACC

The WACC is used as the discount rate to evaluate variouscapital budgeting projects. However, it is important to realizethat the WACC is an appropriate discount rate only for a project ofaverage risk.

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.

1. Turnbull Co. has a target capital structure of 45% debt, 4%preferred stock, and 51% common equity. It has a before-tax cost ofdebt of 11.1%, and its cost of preferred stock is 12.2%.

If Turnbull can raise all of its equity capital from retainedearnings, its cost of common equity will be 14.7%. However, if itis necessary to raise new common equity, it will carry a cost of16.8%.

If its current tax rate is 25%, 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:Round your intermediate calculations to two decimal places.)

a.1.07%

b.0.96%

c.1.34%

d.1.39%

2. Turnbull Co. is considering a project that requires aninitial investment of $270,000. The firm will raise the $270,000 incapital by issuing $100,000 of debt at a before-tax cost of 11.1%,$30,000 of preferred stock at a cost of 12.2%, and $140,000 ofequity at a cost of 14.7%. The firm faces a tax rate of 25%. Whatwill be the WACC for this project?__________ (Note: Round yourintermediate calculations to three decimal places.)

a.9.05

b.13.27

c. 13.87

d.12.06

Consider the case of Kuhn Co.

3. 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 $95.70 per share.

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 $22.35 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 8.7%, and they face a tax rate of 25%. What willbe the WACC for this project?_________ (Note: Round yourintermediate calculations to two decimal places.)

a. 10.83

b. 13.82

c. 14.44

d.12.03