A corporation has the following balance sheet (liabilities side) Current liabili

Question

A corporation has the following balance sheet (liabilities side)

Current liabilities 2,000

Long-term debt   5,000

Preferred stock   2,000

common stock    8,000

retained earnings  3,000

Currently, the riskless interest rate is 8%; the corporate tax rate is 50%; the current price of a share of common stock is $20; and dividends have been level at $1 per share per year for many years.

Recently, company executives have considered expanding the existing business by acquiring a competitor. To do so, they must caluculate the WACC of the firm and estimate the NPV of the acquisition.  Because the acquisition is of the same risk as the firm, the WACC (unlevered equity cost) can be used.  

A financial executive has used the following procedure to calculate the WACC.  Debt and preferred cost are fixed claims offering a fairly secure constant return, and so their before tax cost is assumed to equal the riskless rate.  The dividend yield has held constant at about 5%; so this is used as the cost of new and retained equity (common plus reatined), and 10% current liabilities. Current liabilities are assumed to be costless; therefore the WACC is 4.55%.

Comment of this procedure:

Explanation / Answer

Hi,

Please find the answer as follows:

WACC = 8*(1-.50)*5000/(5000 + 2000 + 11000) + 8*2000/(5000 + 2000 + 11000) + 11000*5*/(5000 + 2000 + 11000) = 5.056 or 5.06%

The approach is not correct, as debt is a tax deductible expense and hence it will reduce the cost of debt. Cost of preferred stock will not get tax benefit and hence no adjustment is required.

Thanks.

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