2. A company wishes to raise funds for a project. It needs 20 million. It decide
ID: 2792957 • Letter: 2
Question
2. A company wishes to raise funds for a project. It needs 20 million. It decides to borrow s million from a bank at 12% per year compounded monthly. It will issue 4 million worth of common stock. The stock price is 12 dollars per share with annual earnings of55 cents per share (ignore growth effects). Retained Earnings will be used for 6 million. The last 5 million will come from bond issuing with a semi-annual dividend payment and 6% annual rate. The effective tax rate for the company is 40%, what is the weighted average cost of capital for this project?Explanation / Answer
Funds Required for the Project =$20,000,000
Borrowing from bank =$5,000,000
Interest Rate =12% per year compounded monthly
Stock Issued =$4,000,000
Stock Price =$12
Constant Annual Earnings =$0.55
Retained Earnings Available =$6,000,000
Bonds Isssued =$5,000,000
Annual Coupon Rate =6% (Paid Semi-Annually)
Tax Rate =40%
After-Tax Cost of Bank Debt, Rd1 = {(1+0.12/12)12 -1}% x (1-0.40) ={1.0112 -1 }% x 0.60 = 12.68% x 0.60=7.609%
After-Tax Cost of Bonds Debt, Rd2 = 6% x (1-0.40) =3.6%
Cost of Equity & Retained Earnings, Re =D/P = 0.55/12 =4.58%
Weighted Average Cost of Capital = W1Rd1 + W2 Rd2 + W3Re
= 5/20x7.609 + 5/20x3.6 + (4+6)/20x4.58
= 1.90 + 0.90 + 2.29
= 3.209%
Hence, the WACC for the company is 3.209%
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