4. Weighted average cost of capital (WACC) Howard Industries has a target capita

ID: 2651931 • Letter: 4

Question

4. Weighted average cost of capital (WACC) Howard Industries has a target capital structure consisting of 30% debt, 15% preferred stock, and 55% common equity. The before-tax YTM on Howard's long-term bonds is 9.5%, its cost of preferred stock is 8%, and its cost of retained earnings is 12.5%. If the firm's tax rate is 40%, what is Howard's WACC if it doesn't have to issue new common stock? 9.79% 9.22% 9.90% 9.56% 10.24% Howard Industries undertakes a variety of projects with different levels of risk. Howard adds 2 percentage points to its WACC for high-risk projects and subtracts 2 percentage points from its WACC for low-risk projects. In other words, the cost of capital for a high-risk project equals WACC + 2%, while a low-risk project uses a cost of capital equal to WACC - 2%. WACC remains the same for average-risk projects. Howard's management is considering the following list of projects, and each project's risk is indicated in the table below. Indicate which projects Howard Industries should accept. Check all projects that should be accepted.

Explanation / Answer

Let’s assume that the overall capital contributed by debt, preferred stock & Common equity be $ 100.

Sources of Capital

Proportion

Contribution

Debt

30%

Preferred Stock

15%

Common Equity

55%

Total

100

Cost of Long Term Bond before Tax

9.50%

Cost of Preferred Stock

Cost of Retained Earnings

12.50%

Weighted Average Cost of Capital = Cost of Long Term Bond before Tax*(1-Tax)*30% + Cost of Preferred Stock*15%+ Cost of Retained Earnings*55%

= 0.0171+0.012+0.069 = 9.79%

Cost of Capital for High Risk Project = 9.79% + 2% = 11.79%

Cost of Capital for Low Risk Project = 9.79% - 2% = 7.79%

Cost of Capital for Average Risk Project = 9.79%

Based on the above details , please find below the status of the projects :

Project

Status

Reject the Project

Accept the Project