The WACC is used as the discount rate to evaluate various ca

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. 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 8.2%, and its cost of preferred stock is 9.3%. If its current tax rate is 40%, 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? If Turnbull 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%. o 077% 0 0.64% 0 0.86% ? 0.54% 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 10.2%, $20,000 of preferred stock at a cost of 11.4%, and $320,000 of equity at a cost of 14.3%. The firm faces a tax rate of 40%, what will be the WACC for this project?

Solution

1. WACC= [(W_d)[(K_d)(1-t)]+ [(W_pf)(K_pf)]+ [(W_ce)(K_ce)]

here W_d =Weight of Debt = 58%

W_pf =Weight of Preferred Stock = 6%

W_ce =Weight of Common Equity = 36%

K_d =Cost of Debt = 8.20%

K_pf =Cost of Preferred Stock = 6.00%

K_ce =Cost of Common Equity = 14.20% (If new captial is raised) or 12.40% (if retained earnings are used)

t = Tax Rate = 40%

Option I = If retained earnings are used, WACC will be as below:

WACC= [(W_d)[(K_d)(1-t)]+ [(W_pf)(K_pf)]+ [(W_ce)(K_ce)]

              [(0.58)(.082)(1-.40)] + [(.06)(.06)] + [(.36)(.124)] = 0.0768 or 7.68%

Option II = If new capital is raised, WACC will be as below:

WACC= [(W_d)[(K_d)(1-t)]+ [(W_pf)(K_pf)]+ [(W_ce)(K_ce)]

              [(0.58)(.082)(1-.40)] + [(.06)(.06)] + [(.36)(.142)] = 0.0832 or 8.32%

Therefore, Turnbull\'s WACC would be higher by = 8.32 - 7.68 = 0.64%

The correct answer is 0.64%