Kuhn Corporation is considering a new project that will require an initial inves
ID: 2760489 • Letter: K
Question
Kuhn Corporation is considering a new project that will require an initial investment of $4,000,000. It has a target capital structure consisting of 45% debt, 4% preferred stock, and 51% common equity. Kuhn has noncallable bonds outstanding that mature in 15 years with a face value of $1,000, an annual coupon rate of 11%, and a market price of $1,555.38. The yield on the company’s current bonds is a good approximation of the yield on any new bonds that it issues. The company can sell shares of preferred stock that pay an annual dividend of $8.00 at a price of $95.70 per share. Kuhn Corporation does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 8.00% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.70%, and they face a tax rate of 40%. Kuhn Company’s WACC for this project will be what?
Explanation / Answer
Step1: Computation of the YTM of the bond.We have,
Value of the bond = C [ 1 - 1/(1+r)n ] / r + F.V / (1+r)n
If r = 10%
Value of bond = (11% x 1,000) [ 1 -1/ (1.10)15 ] /0.10+ 1,000/(1.10)15
Value of bond = 110 [ 1 - 0.23939] / 0.10 + 1,000 x 0.23939
Value of bond = 836.67 + 239.39 = $ 1,076.06
If r = 15%,
Value of bond = (11% x 1,000) [ 1 -1/ (1.15)15 ] /0.15+ 1,000/(1.15)15
Value of bond = 110 [ 1 - 0.12289] / 0.15 + 1,000 x 0.12289
Value of bond = 643.21+ 122.89 = $ 766.10
using the interpolation,
10 + (15 - 10) (1,076.06 - 1,555.38) / ( 1,076.06 - 766.10)
10 + 5 x - 479.32 / 309.96
10 - 7.73 = 2.27%
Hence the interest rate is 2.27%
Step2: Computation of cost of preference capital.We have,
Cost of preference capital = Dividend / selling price
Cost of preference capital = 8.00 / 95.70 = 0.0836*100 = 8.36%
Step3: Cost of common stock.We have,
Net selling price = 33.35 - (8% x 33.35)
Net selling price = 33.35 - 2.67 = $ 30.68
Price of stock = Expected dividend / ( Cost of capital - growth rate)
30.68 = 2.78 / ( Cost of capital - 0.0870)
Cost of capital - 0.0870 = 2.78/30.68 = 0.0906
Cost of capital = 0.0906 + 0.0870 = 0.1776*100 = 17.76%
Step4: Computation of the WACC.We have,
WACC = (4,000,000 X 45%) X 2.27%X(1-0.40) / 4,000,000 +(4,000,000 X 4%) X 8.36% / 4,000,000+(4,000,000 X 51%) X 17.76% / 4,000,000
WACC = 0.61 + 0.33 + 9.06 = 10.0%
Hence, the WACC for the project is 10.0%
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