Kuhn Co. is considering a new project that will require an initial investment of
ID: 2764626 • Letter: K
Question
Kuhn Co. is considering a new project that will require an initial investment of $20 million. It has a target capital structure of 35% debt, 2% preferred stock, and 63% common equity. Kuhn has noncallable bonds outstanding that mature in five years with a face value of $1000, an annual coupon rate of 10%, and a market price of $1,050.76. The yield on the company's current bonds is a good approximation of teh yield on any new bonds that it issues. The compnay can sell shares of preferred stock that pay an annual dividend of $9 at a price of 92.25 per share. Kuhn does not have any retained earnings 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 $22.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 3% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 9.2%, and they face a tax rate of 40%. Determine what Kuhn Company's WACC will be for this project. a. 14.40% b. 15.89% c. 13.51% d. 18.27%
Explanation / Answer
Bond price = Coupon rate * Face value * [1- (1 + YTM)-No. of years] / YTM + Face value / (1+YTM)No. of years
=> $1,050.76 = 10% * $1,000 * [1- (1 + YTM)-5] / YTM + $1,000 / (1+YTM)5
Now using solver function of excel we get, YTM = 8.71%
Again YTM = Before tax cost of debt = 8.71%
Cost of preferred stock = Annual dividend / Price
= $9 / $92.25
= 9.76%
Cost of equity = Dividend to be paid / [Price * (1 - floatation cost)] + Constant growth
= $2.78 / [$22.35 * (1 - 3%)] + 9.2%
= 22.02%
WACC = 35% * (1 - 40%) * 8.71% + 2% * 9.76% + 63% * 22.02%
= 15.89% which is option (b).
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