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7. Solving for a firm's WACC Aa Aa E A firm's weighted average cost of capital (WACC) is used as the discount rate to evaluate various capital budgeting projects. However, remember 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 Cold Goose Metal Works Cold Goose Metal Works has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 8.2%, and its cost of preferred stock is 9.3%. If its current tax rate is 40%, how much higher will Cold Goose'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? If Cold Goose can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%. 01.06% 1.15% O 0.78% O 0.92% Consider the case of Red Oyster Seafood Company The CFO of Red Oyster Seafood Company is trying to determine the company's WACC. He has determined that the company's before-tax cost of debt is 8.70%. The company currently has $750,000 of debt, and the CFO believes that the book value of the company's debt is a good approximation for the market value of the company's debt. The firm's cost of preferred stock is 9.90%, and the book value of preferred stock is $45,000. Its cost of equity is 13.20%, and the company currently has $500,000 of common equity on its balance sheet. The CFO has estimated that the firm's market value of preferred stock is $78,000, and the market value of its common equity is $880,000. The firm's cost of preferred stock is 9.90%, and the book value of preferred stock is $45,000. Its cost of equity is 13.20%, and the company currently has $500,000 of common equity on its balance sheet. The CFO has estimated that the firm's market value of preferred stock is $78,000, and the market value of its common equity is $880,000. If Red Oyster is subject to a tax rate of 40%, Red Oyster Seafood Company's WACC is Consider the case of Green Penguin Pencil Company Green Penguin Pencil Company is considering a new project that will require an initial investment of $4 million. It has a target capital structure of 35% debt, 2% preferred stock, and 63% common equity. Green Penguin Pencil 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 $1,555.38. 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 new shares of preferred stock that pay an annual dividend of $8 at a price of $95.70 per share. Assume that Green Penguin Pencil new preferred shares can be sold without incurring flotation costs. Green Penguin Pencil 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 $22.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 3% 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 40%. Green Penguin Pencil's WACC for this project will be: 14.88% 17.11% O 17.86% O 11.90%
