Question

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 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 8.20%, and its cost of preferred stock is 9.30%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.40%. However, if it is necessary to raise new common equity, it will carry a cost of 14.20%. higher if it has to raise additional common equity If its current tax rate is 40%, Turnbull's weighted average cost of capital (WACC) will be 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 $270,000.00. The firm will raise the $270,000.00 in capital by issuing $100,000.00 of debt at a before-tax cost of 10.20%, $30,000.00 of preferred stock at a cost of 11.40%, and $140,000.00 of equity at a cost of 14.30%. The firm faces a tax rate of 40%. The WACC for this project is

drop down 1 options: 0.70%, 0.58%, 0.74%, 0.64%

drop down 2 options: 10.95%, 9.31%, 8.21%, 8.76%

drop down 3 options: 9.48%, 11.06%, 10.53%, 10.00%

Answer 1

1.
=weight of equity*(cost of new common stock-cost of retained earnings)=36%*(14.2%-12.4%)=0.648%

2.
=(debt*before tax cost*(1-tax rate)+preferred stock*cost of preferred stock+equity*cost of equity)/total investment
=(100000*10.2%*(1-40%)+30000*11.4%+140000*14.3%)/270000=10.948%

3.
=proportion of debt*cost of debt*(1-tax rate)+proportion of preferred stock*cost of preferred stock+proportion of equity*cost of equity
=58%*RATE(15,11%*1000,-1555.38,1000)*(1-40%)+6%*8/92.25+36%*(2.78/(22.35*(1-8%))+8.70%)
=10.53%