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 $45\%$ debt, $4\%$ preferred stock, and $51\%$ common equity. It has a before$-$tax cost of debt of

$11\mathrm{.}10\%,$ and its cost of preferred stock is $12\mathrm{.}20\%.$ If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will

be $14\mathrm{.}70\%.$ However, if it is necessary to raise new common equity, it will carry a cost of $16\mathrm{.}80\%.$

If its current tax rate is $40\%,$ Turnbull's weighted average cost of capital $($WACC$)$ will be

$1\mathrm{.}28\%$

$1\mathrm{.}07\%$

$0\mathrm{.}91\%$

$1\mathrm{.}23\%$

higher if it has to raise additional common equity

capital by issuing new common stock instead of raising the funds through retained earnings.

Turnbull Company is considering a project that requires an initial investment of $$570,000\mathrm{.}00.$ The firm will raise the $$570,000\mathrm{.}00$ in capital by issuing

$$230,000\mathrm{.}00$ of debt at a before$-$tax cost of $10\mathrm{.}20\%,$$$20,000\mathrm{.}00$ of preferred stock at a cost of $11\mathrm{.}40\%,$ and $$320,000\mathrm{.}00$ of equity at a cost of

$14\mathrm{.}30\%.$ The firm faces a tax rate of $40\%.$ The WACC for this project is

$10\mathrm{.}90\%$

$7\mathrm{.}63\%$

$9\mathrm{.}27\%$

$10\mathrm{.}36\%$