Back to Assignment Attempte Do No Harm/2 1. The basic WACC equation The calculation of WACC involves calculating the weighted average of the required rates of return on debt, preferred stock, and common equity, where the weights equal the percentage of each type of financing in the firm's overall capital structure. is the symbol that represents the cost of raising capital through retained earnings in the weighted average cost of capital (WACC) equation. Mitchell Co. has $2.7 million of debt, $3 million of preferred stock, and $2.1 million of common equity. What would be its weight on preferred stock? O 0.27 0 0.38 O 0.35 O 0.42 Grade It Now Save & Continue Attempte Do No Harm/3 2. An overview of a firm's cost of debt To calculate the after-tax cost of debt, multiply the before-tax cost of debt by Western Gas & Electric Company (WGC) can borrow funds at an interest rate of 11.10% for a period of six years. Its marginal federal-plus-state tax rate is 25%. WGC's after-tax cost of debt is (rounded to two decimal places). At the present time, Western Gas & Electric Company (WGC) has 5-year noncallable bonds with a face value of $1,000 that are outstanding. These bonds have a current market price of $1,438.04 per bond, carry a coupon rate of 14%, and distribute annual coupon payments. The company incurs a federal-plus-state tax rate of 25%. IT WGC wants to issue new debt, what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)? (Note: Round your YTM rate to two decimal place.) 0 2.48% 0 3.57% 03.10% 0 2.79% Grade It Now Save & Continue Continue without saving Attempte Do No Harm/2 3. The cost of preferred stock Preferred stock is a hybrid security, because it has some characteristics typical of debt and others typical of equity. The following table lists various characteristics of preferred stock. Determine which of these characteristics is consistent with debt and which is consistent with equity. Characteristics Debt Equity Usually has no voting rights. No tax adjustments are made when calculating the cost of preferred stock. 0 Consider the case of Bogdan Enterprises: At the present time, Bogdan Enterprises does not have any preferred stock outstanding but is looking to include preferred stock in its capital structure in the future. Bogdan has found some institutional investors that are willing to purchase its preferred stock issue provided that it pays a perpetual dividend of $13 per share. Ir the investors pay $139.84 per share for their investment, then Bogdan's cost of preferred stock (rounded to four decimal places) will be Grade It Now Save & Continue Continue without saving 4. The cost of retained earnings True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. True O False The cost of equity using the CAPM approach The current risk-free rate of return (TRF) is 4.67% while the market risk premium is 5.75%. The Jefferson Company has a beta or 0.92. Using the capital asset pricing model (CAPM) approach, Jefferson's cost of equity is The cost of equity using the bond yield plus risk premium approach The Hoover Company is closely held and therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company's cost of internal equity. Hoover's bonds yield 11.52%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 4.95%. Based on the bond-yield-plus-risk-premium approach, Hoover's cost of internal equity is: 0 16.47% 0 20.59% O 15.65% O 18.12% The cost of equity using the discounted cash flow (or dividend growth) approach Grant Enterprises's stock is currently selling for $45.56 per share, and the firm expects its per-share dividend to be $2.35 in one year. Analysts project . the firm's growth rate to be constant at 7.27%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Grant's cost of internal equity? O 11.81% O 16.78% O 13.05% O 12.43% Estimating growth rates It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF or DG approach. In general, there are three available methods to generate such an estimate: Carry forward a historical realized growth rate, and apply it to the future. . Locate and apply an expected future growth rate prepared and published by security analysts. Use the retention growth model. Suppose Grant is currently distributing 40% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 22%. Grant's estimated growth rate is Girde It Now Gay Continue Back to Assignment Attempte Do No Harm/4 5. The cost of new common stock True or False: The following statement accurately describes how firms make decisions related to issuing new common stock. If a firm needs additional capital from equity sources once its retained earnings breakpoint is reached, it will have to raise the capital by issuing new common stock. O True: Firms will raise all the equity they can from retained earnings before issuing new common stock, because capital from retained earnings is cheaper than capital raised from issuing new common stock. O False: Firms raise capital from retained eamings only when they cannot issue new common stock due to market conditions outside of their control Alpha Moose Transporters is considering investing in a one-year project that requires an initial investment of $500,000. To do so, it will have to issue new common stock and will incur a flotation cost of 2.00%. At the end of the year, the project is expected to produce a cash inflow of $550,000. The rate of return that Alpha Moose expects to earn on its project (net of its flotation costs) is (rounded to two decimal places). Sunny Day Manufacturing Company has a current stock price of $22.35 per share, and is expected to pay a per-share dividend of $2.03 at the end of the year. The company's earnings and dividends growth rate are expected to grow at the constant rate of 5.20% into the foreseeable future. Il Sunny Day expects to incur flotation costs of 5.00% of the value of its newly-raised equity funds, then the flotation-adjusted (net) cost of its new common stock (rounded to two decimal places) should be Alpha Moose Transporters Co.'s addition to earnings for this year is expected to be $857,000. Its target capital structure consists of 35% debt, 5% preferred, and 60% equity. Determine Alpha Moose Transporters's retained earnings breakpoint: O $1,356,916 O $1,428,333 O $1,642,583 O $1,571,166 Grade It Now Save & Continue Continue without saving Back to Assignment Attempts Do No Harm/3 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. a 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 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 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? (Note: Round your intermediate calculations to two decimal places.) 0 1.03% O 0.95% O 0.76% O 0.65% 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 9.6%, $20,000 of preferred stock at a cost of 10.7%, and $320,000 of equity at a cost of 13.5%. 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 $4 million. It has a target capital structure of 45% debt, 4% preferred stock, and 51% 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 company's 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 9.2%, 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.) Grade It Now Save & Continue Continue without saving