The WACC is used as the discount rate to evaluate various capital budgeting proj
ID: 2787961 • Letter: T
Question
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 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2% 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 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8% O 0.94% 0.98% 0.75% 0.86% Turnbull Co. is considering a project that requires an initial investment of $1,708,000. The firm will raise the $1,708,000 in capital by issuing $750,000 of debt at a before-tax cost of 10.2%, $78,000 of preferred stock at a cost of 11.4%, and $880,000 of equity at a cost of 14.3%. The firm faces a tax rate of 40%. what will be the WACC for this project?Explanation / Answer
1. Turnball Co.
Increase in WACC = Weight of equity * (Increase in cost of equity)
= 0.36 * (16.8% - 14.7%) = 0.36 * 2.1%
= 0.75%
Computation of WACC for the project:
WACC = weight of debt * cost of debt *(1-tax rate) + weight of Preferred stock * cost of preferred + weight of equity * cost of equity
= (750,000/ 1,708,000) * 10.2%(1-40%) + (78,000/ 1,708,000) * 11.4% + (880,000/ 1,708,000)* 14.3%
= 0.44 *10.2% + 0.045 * 11.4% + 0.515* 14.3%
= 12.37%
2. Kuhn Co.
WACC = weight of debt * cost of debt *(1-tax rate) + weight of Preferred stock * cost of preferred + weight of equity * cost of equity
Cost of equity = D1 / p*(1-f) + g
= 1.36/ 22. 35(1-3%) + 9.2% = 1.36/ 21.68 + 9.2% = 15.47%
Cost of preferred stock = Dividend / price = 9/ 95.7 = 9.4%
Cost of debt = rate(PMT = $1,000*10% = 100, face value = $1,000, Price = $1,050.76, n = 5years)
using financial calculator, we got rate = 8.71%
Therefore, WACC = weight of debt * cost of debt *(1-tax rate) + weight of Preferred stock * cost of preferred + weight of equity * cost of equity
= 0.45 *5.23% + 0.04 * 9.4% + 0.51* 15.47%
= 10.62%
Tax rate is the factor, which is outside firm's control because government will fix it.
3. Edinburgh case:
Reject the project.
It should be rejected because WACC exceeds project expected return.
A project can only be accepted if it is expected to generate a return more than the required rate of return i.e. the WACC. In this case an expected return of 12% against the WACC of 14% .
Division H project should be rejected since its return is less than the risk- based cost of capital for the division.
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