7. Solving for the WACC Aa Aa The WACC is used as the discount rate to evaluate

Question

7. Solving for the WACC Aa Aa The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address. Consider the case of Turnbull Co. Turnbull Co. has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 8.2%, and its cost of preferred stock is 9.3%. If its current tax rate is 40%, how much higher will Turnbull's weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%. O 0.83% O 0.78% O 1.10% O 0.92%

Explanation / Answer

WACC=(Wt of debt*after tax cost of debt)+(Wt of preferree stock*cost of preferred stock)+(Wt of common stock*cost of common stock)
WACC with retained earnings=(45%*8.2%*(1-40%))+(51%*12.4%)+(4%*9.3%)=8.91%
WACC with new funds raised by equity=(45%*8.2%*(1-40%))+(51%14.2%)+(4%*9.3%)=9.83%
Difference is =9.83%-8.91%=0.92%

2) debt=100000
Preferred stock=30000
Equity=140000
Wt o fdebt=100000/270000=37.04%
Wt of equity=140000/270000=51.85%
Wt of preferred stock=30000/270000=11.11%
WACC=(Wt of debt*after tax cost of debt)+(Wt of preferree stock*cost of preferred stock)+(Wt of common stock*cost of common stock)
=(37.04%*11.1%*(1-40%))+(11.11%*12.2%)+(51.85%*14.7%)
=11.44%

Related Questions

Navigate

• Browse (All)
• Browse 7
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.