2. A company wishes to raise funds for a project. It needs 20 million. It decide

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

Total Capital Required = $20 million.

Weight of bank Loan = 25%

Weight of external equity = 20%

Weight of internal equity = 30%

Weight of bond = 25%

Effective cost of bank borrowing = [(1 + 12% / 12) ^ 12] - 1

= 1.1268 - 1

= 12.68%

Effective cost of bank borrowing is 12.68%

After tax cost of bank borrowing = 12.68% × (1 - 40%)

= 7.61%

After tax cost of borrowing is 7.61%.

Floatation cost in issue of stock is zero,so, cost of retained earnings is equal to cost of external financing.

So, Cost of equity = $0.55 / 12

= 4.58%

Cost of equity is 4.58%.

Coupon rate on bond = 6%

After tax cost fof bond = 6% × (1 - 40%)

= 3.60%.

After tax cost of bond is 3.60%.

Now,WACC is calculated below:

WACC = (25% × 7.61%) + (20% + 30%) × 4.58% + (25% × 3.60%)

= 1.90% + 2.29% + 0.90%

= 5.09%

WACC of company is 5.09%.

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