2. Solving for the WACC The WACC is used as the discount rate to evaluate variou
ID: 2810970 • Letter: 2
Question
2. Solving for the WACC The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is only an appropriate discount rate for a project of average risk-in other words, a project that has the same beta as the company. If a project has less risk than the overall company risk, it should be evaluated with a lower discount rate; if a project is riskier than the overall company risk, it should be evaluated using a discount rate higher than the company WACC 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% 0.90% 0.64% 0.68% o 0.75% Turnbull Co. is considering a project that requires an initial investment of $570,000. The firm will raise the $570,000 in capital by issuing $230,000 of debt at a before-tax cost of 11.1%, $20,000 of preferred stock at a cost of 12.2% and $320,000 of equity at a cost of 14.7%. The firm faces a tax rate of 40%. what will be the WACC for this project?Explanation / Answer
Turnbull Case
a.
Weight of debt in capital structure is 58%, weight of preferred stock is 6% and weight of equity is 36%. Cost of retained earnings is 14.70% and cost of external financing is 16.80%.
In WACC calculation if cost of equity changes because of external financing then it will affect only equity component of WACC calculation. debt and preferred stock component remains unaffected.
Change in WACC with change in cost of equity from 14.70% to 16.80% is calculated below:
Change in WACC = 36% × (16.80% - 14.70%)
= 36% × 2.10%
= 0.75%
WACC change by 0.75%.
Option (D) is correct answer.
2.
Total capital required = $570,000
Debt Weight = $230,000 / $570,000
= 40.35%
Preferred stock weight = $20,000 / $570,000
= 3.51%
Equity weight = $320,000 / $570,000
= 56.14%.
Before tax cost of debt = 11.10%
After tax cost of debt = 11.10% × (1 - 40%)
= 6.66%
After tax cost of debt is 6.66%.
Now, WACC is calculated below:
WACC = (40.35% × 6.66%) + (3.51% × 12.20%) + (56.14% × 14.70%)
= 2.69% + 0.43% + 8.25%
= 10.32%
WACC of company is 11.37%.
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