Weighted Average Cost of Capital

You are part of a team that is planning to present to the strategic planning and

investment committee your company$$s weighted average cost of capital. You

plan in discussing the appropriate weights, how the WACC is used in capital

budgeting and in corporate valuation, and any adjustments or other factors that

could impact the overall cost of capital.

The company utilizes three forms of capital in funding projects. Your job is to

estimate the effective cost of each and then to calculate the company$$s weighted

average cost of capital.

Below is useful data that will help you in your analysis:

Current $10-$year treasury rate $=4\mathrm{.}50\%$

Current Market Risk Premium $=7\mathrm{.}0\%$

Company$$s debt is rated A$.$ A rated debt usually carries a $0\mathrm{.}75\%$ premium to

comparable treasuries

Bond Data:

The company has two semi$-$annual coupon bonds that are traded in the market.

The first bond has a $6\%$ coupon and is currently priced at $$1057.$ The bond is

callable in $2-$years at $$1050.$ The second bond has a $3\mathrm{.}0\%$ coupon and is currently

priced at $$830$ and is callable in $2$ years at $$1050.$ Both bonds mature in $10$ years

and have a face of $$1000.$ The company$$s tax rate is $25\%.$

Preferred Data

The company has outstanding preferred stock that has a $6\%$ coupon and matures

in $100$ years. It is not callable. The par value is $$100,$ and it currently sells for $$80.$

If they were to sell additional preferred, they would incur flotation costs of $10\%.$

Common Stock

The company$$s beta $=0\mathrm{.}9.$ The current stock price is $$50$ and the expected

dividend next year D$(1)=$ $$3\mathrm{.}00.$ It is expected that the dividend will grow at a

constant rate of $4\%$ indefinitely.

Questions

$1-$ Using a target capital structure of $30\%$ debt, $60\%$ common stock and $10\%$

preferred, what is the weighted average costs of capital that will be used to

assess new projects?

For this problem assume that all common stock is raised as retained earnings and

that any additional debt that is used will be $0\mathrm{.}5\%$ above the company$$s current

long$-$term cost of borrowing. Current estimated cost $+0\mathrm{.}5\%$

$2-$ Using the same target capital structure, recalculate the WACC, assuming

that there are no retained earnings, and that new common equity issuance

will incur a flotation cost of $15\%.$ Only reconfigure your cost of equity using

the market implied cost of equity method $($do not use the CAPM$)$ and keep

other component costs the same.

$3-$ Why are there flotation costs when issuing new common equity?

$4-$ If a company has projects that have different levels of risk, how should they

account for that when incorporating the WACC?

$5-$ Why does it make sense that debt is usually the cheapest form of capital

and why doesn$$t the firm just borrow $100\%$ of the capital needed?

$6-$ Why is it better to use a longer$-$term cost of borrowing when calculating

the WACC?