7. Solving for the WACC

The weighted average cost of capital (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.

Consider the case of Turnbull Company.

Turnbull Company has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.10%, and its cost of preferred stock is 12.20%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.70%. However, if it is necessary to raise new common equity, it will carry a cost of 16.80%.

1. If its current tax rate is 40%, Turnbulls weighted average cost of capital (WACC) will be (0.98%, 0.75%, 0.86%, OR 0.64%) higher if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings.

2. Turnbull Company is considering a project that requires an initial investment of $270,000.00. The firm will raise the $270,000.00 in capital by issuing $100,000.00 of debt at a before-tax cost of 9.60%, $30,000.00 of preferred stock at a cost of 10.70%, and $140,000.00 of equity at a cost of 13.50%. The firm faces a tax rate of 40%. The WACC for this project is (7.22%, 11.87%, 8.77%, OR 10.32%).

Consider the case of Kuhn Corporation.

Kuhn Corporation is considering a new project that will require an initial investment of $20,000,000. It has a target capital structure consisting of 58% debt, 6% preferred stock, and 36% common equity.

Kuhn has noncallable bonds outstanding that mature in five years with a face value of $1,000, an annual coupon rate of 10%, and a market price of $1,050.76. 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 $9.00 at a price of $92.25 per share.

Kuhn Corporation 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 $2.78 at the end of next year. Flotation costs will represent 3.00% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.70%, and they face a tax rate of 40%.

3. Kuhn Companys WACC for this project will be (8.46%, 9.95%, 10.45%, OR 11.94%).