$1.$ WACC and Optimal Capital Budgeting $($Formula Approach$)$

Step $1$: Concept Clip: WACC and Optimal Capital Budgeting

The WACC and capital budgeting are fundamental concepts in finance.

Watch the video and answer the question that follows.

Suppose that the present values of the inflow from a project are greater than the cost of the investment.

True or False: According to capital budgeting, the project will be funded.

False

True

Read the following passage of text and answer the following question.

You just learned that the present value of future cash flows from a project is a critical component in the capital budgeting decision of whether to fund a project or not. But what discount rate should be used to discount those future cash inflows from a project? Estimating this cost of capital is an important concept in finance.

Firms typically estimate a weighted average cost of capital $($WAAC$)$ in order to use to discount future cash flows in the capital budgeting process. This WAAC weights the costs of various types of capital to arrive at a weighted average cost of capital. The weights used are based on the firm$$s target capital structure, rather than the present capital structure, when taking on new projects.

When raising capital from investors, there are three major categories $($or components$)$ from which a firm can draw: debt, common stock, and preferred stock. The component cost represents the cost of that component. These component costs are the costs used in the estimation of the WAAC.

True or False: The current capital structure, not the target capital structure, is used when calculating the WAAC during the capital budgeting process.

True

False

Step $2$: Learn: WACC and Optimal Capital Budgeting

Watch the following video for an example, then answer the questions that follow.

Suppose Mullens Corporation is considering three average$-$risk projects with the following costs and rates of return:

Project

Cost

Expected Rate of Return

$1$ $$2,50018\mathrm{.}00\%$

$2$ $$3,00011\mathrm{.}00\%$

$3$ $$2,75013\mathrm{.}00\%$

Mullens estimates that it can issue debt at a rate of rd$=15\mathrm{.}00\%$

and a tax rate of T$=20\mathrm{.}00\%$

$.$ It can issue preferred stock that pays a constant dividend of Dp$=$$$20\mathrm{.}00$

per year and at Pp$=$$$100\mathrm{.}00$

per share.

Also, its common stock currently sells for P$0=$$$45\mathrm{.}00$

per share. The expected dividend payment of the common stock is D$1=$$$4\mathrm{.}50$

and the dividend is expected to grow at a constant annual rate of g$=5\mathrm{.}00\%$

per year.

Mullens$$ target capital structure consists of ws$=75\mathrm{.}00\%$

common stock, wd$=15\mathrm{.}00\%$

debt, and wp$=10\mathrm{.}00\%$

preferred stock.

According to the video, the after$-$tax cost of debt can be stated as $.$ Plugging in the values for rd

and $($T$)$

yields an after$-$tax cost of debt of approximately $.$

According to the video, the cost of preferred stock can be stated as $.$ Plugging in the values for Dp

and Pp

yields a cost of preferred stock of of approximately $.$

Hint: Assume no flotation costs.

According to the video, the cost of common stock can be stated as $.$ Plugging in the values for D$1$

$,$ P$0$

$,$ and g

yields a cost of common stock of approximately $.$

Recall that the equation for the weighted average cost of capital $($WAAC$)$ can be stated as:

WAAC

$=$

$(\%$ of debt$)\backslash$times $($After$-$tax cost of debt$)$

$+(\%$ of preferred stock$)\backslash$times $($Cost of preferred stock$)$

$+(\%$ of Common equity$)\backslash$times $($Cost of common equity$)$

Plugging in the relevant values into the formula for WACC yields a WAAC of approximately $.$

Suppose that Mullens will only accept projects with an expected rate of return that exceeds the WAAC.

Which of the following projects will Mullens accept? Check all that apply.

Project $1$

Project $2$

Project $3$

Step $3$: Practice: WACC and Optimal Capital Budgeting

Now it$$s time for you to practice what you$$ve learned.

Suppose Mullens Corporation is considering three average$-$risk projects with the following costs and rates of return:

Project

Cost

Expected Rate of Return

$1$ $$3,50037\mathrm{.}00\%$

$2$ $$4,00027\mathrm{.}00\%$

$3$ $$3,75035\mathrm{.}00\%$

Mullens estimates that it can issue debt at a rate of rd$=25\mathrm{.}00\%$

and a tax rate of T$=15\mathrm{.}00\%$

$.$ It can issue preferred stock that pays a constant dividend of Dp$=$$$20\mathrm{.}00$

per year and at Pp$=$$$80\mathrm{.}00$

per share.

Also, its common stock currently sells for P$0=$$$16\mathrm{.}00$

per share. The expected dividend payment of the common stock is D$1=$$$4\mathrm{.}00$

and the dividend is expected to grow at a constant annual rate of g$=10\mathrm{.}00\%$

per year.

Mullens$$ target capital structure consists of ws$=75\mathrm{.}00\%$

common stock, wd$=15\mathrm{.}00\%$

debt, and wp$=10\mathrm{.}00\%$

preferred stock.

The after$-$tax cost of debt is approximately $.$

The cost of preferred stock is approximately $.$

The cost of common stock is approximately $.$

The WAAC is approximately $.$

Suppose that Mullens will only accept projects with an expected rate of return that exceeds the WAAC.

Which of the following projects will Mullens accept? Check all that apply.

Project $1$

Project $2$

Project $3$