WACC Estimation-Problem 9-15 On January 1 the total market value of the Tysselan
ID: 2713740 • Letter: W
Question
WACC Estimation-Problem 9-15
On January 1 the total market value of the Tysseland Company was $60 million. During the year the company plans to raise and invest $30 million in new projects. The firm's present market value capital structure shown below is considered to be optimal. There is no short term debt.
Debt $30,000,000
Common Equity 30,000,00
Total Capital $60,000,000
New Bonds will have an 8% coupon rate and they will be sold at par. Common Stock is currently selling at $30 a share. The stockholder's required rate of return is estimated to be 12% consisting of a dividend yeild of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so the dividend yeild is $1.20/$30 = 4%). The marginal rate is 40%.
(a) In order to maintain the present capital structure, how much of the new investment must be financed by common equity? Answer is $15,000,000--show all work and formulas to support answer
(b) Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of equity, what is its WACC? Answer is 8.4%--show all work and formulas.
(c) Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking what will happen to the WACC? No Numbers are required to answer this question.
Explanation / Answer
Answer:
The Optimal capital structure weights:
Debt = $30 million/$60 million = 0.5 = 50%
Equity = $30 million/$60 million = 0.5 = 50%
a)
Fund required for new project = $30 million
To maintain the capital structure, the funds is required to be raised in weight of existing capital structure:
i.e. Debt:equity = 50%:50% = $15,000,000:$15,000,000
The amount of new investment must be financed by common equity = $15,000,000
b) Instead of issuing fresh shares, retained earning will be used.
The cost of retained earning will be same as cost of equity = 12%
Post tax cost of debt = Pre tax cost of debt(1-tax rate) = 8%(1-0.4) = 4.8%
The WACC = 0.5*12% + 0.5*4.8% = 8.4% (ans)
c)
The WACC will remain the same, as the cost of retained earning in given case is same as cost of equity. So the WACC will not change.
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