6. 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 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 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%.

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%.

If its current tax rate is 25%, how much higher will Turnbulls 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? (Note: Round your intermediate calculations to two decimal places.)

A) 1.34%

B) 1.07%

C) 0.96%

D) 0.91%

Turnbull Co. is considering a project that requires an initial investment of $570,000. The firm will raise the $570,000 in the capital by issuing $230,000 of debt at a before-tax cost of 8.7%, $20,000 of preferred stock at a cost of 9.9%, and $320,000 of equity at a cost of 13.2%. The firm faces a tax rate of 25%. What will be the WACC for this project? _____ (Note: Round your intermediate calculations to three decimal places.)

Consider the case of Kuhn Co.

Kuhn Co. is considering a new project that will require an initial investment of $45 million. It has a target capital structure of 35% debt, 2% preferred stock, and 63% common equity. Kuhn has noncallable bonds outstanding that mature in 15 years with a face value of $1,000, an annual coupon rate of 11%, and a market price of $1555.38. The yield on the companys current bonds is a good approximation of the yield on any new bonds that it issues. The company can sell shares of preferred stock that pay an annual dividend of $9 at a price of $95.70 per share.

Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $1.36 at the end of next year. Flotation costs will represent 8% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.7%, and they face a tax rate of 25%. What will be the WACC for this project? _____ (Note: Round your intermediate calculations to two decimal places.)

7. Factors that affect the cost of capital equation

Each of the following factors affects the weighted average cost of capital (WACC) equation. Which of the following factors are outside a firms control? Check all that apply.

A) Interest rates in the economy

B) The performance of index funds, such as the S&P 500

C) The firms capital structure

The impact of cost of capital on managerial decisions

Consider the following case:

National Petroleum Refiners Corporation (NPR) has two divisions, L and H. Division L is the companys low-risk division and would have a weighted average cost of capital of 8% if it was operated as an independent company. Division H is the companys high-risk division and would have a weighted average cost of capital of 14% if it was operated as an independent company. Because the two divisions are the same size, the company has a composite weighted average cost of capital of 11%. Division H is considering a project with an expected return of 12%.

Should National Petroleum Refiners Corporation (NPR) accept or reject the project?

A) Reject the project

B) Accept the project

On what grounds do you base your acceptreject decision?

A) Division Hs project should be accepted, as its return is greater than the risk-based cost of capital for the division.

B) Division Hs project should be rejected since its return is less than the risk-based cost of capital for the division.