Question

Turnbull Co. 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 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%.

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? (Note: Round your intermediate calculations to two decimal places.)

0.92%

1.06%

1.01%

1.20%

Turnbull Co. is considering a project that requires an initial investment of $270,000. The firm will raise the $270,000 in capital by issuing $100,000 of debt at a before-tax cost of 8.7%, $30,000 of preferred stock at a cost of 9.9%, and $140,000 of equity at a cost of 13.2%. The firm faces a tax rate of 40%. What will be the WACC for this project?

Answer 1

Higher WACC If new common equity is raised instead of raising through retained earnings:

00 4 A с 1 2 Target Capital Structure: 3 Debt 45% Preferred Stock 4% 5 Common Equity 51% 6 Before tax cost of debt 8.20% Given in question 7 Cost of preferred stock 9.30% 8 Cost of common equity (retained earnings) 12.40% 9 Cost of new common equity 14.20% 10 Tax Rate 40% 11 After tax cost of debt 4.92% =B6*(1-B10) 12 13 Calculation of WACC 14 WACC = (After Tax Cost of Debt * Debt % of total capital)+(Cost of Preferred Stock * Preferred Stock % of 15 total capital)+(Cost of Common Equity * Common Equity % of total capital) 16 If retained earnings are used 8.91% =(B3*B11)+(B4*B7)+(B5*B8) 17 If new common equity is raised 9.83% =(B3*B11)+(B4*B7)+(B5*B9) 18 Higher WACC If new common equity is raised 0.92% =B17-B16

Thus, Higher WACC If new common equity is raised = 0.92% (1st option)

WACC of the project:

A B с 20 21 Initial Investment $270,000 22 Debt Value $100,000 Given in question 23 Before Tax Cost of Debt 8.70% 24 Tax Rate 40% 25 After Tax Cost of Debt 5.22% =(B23*(1-B24)) 26 Preferred Stock Value $30,000 27 Cost of Preferred Stock 9.90% Given in question 28 Equity Stock Value $140,000 29 Cost of Equity Stock 13.20% 30 31 Calculation of WACC 32 WACC = (After Tax Cost of Debt * Debt % of total capital)+(Cost of Preferred Stock * Preferred Stock % of 33 total capital)+(Cost of Common Equity * Common Equity % of total capital) 34 Debt % of Total Investment 37.04% =B22/$B$21 35 Preferred Stock % of Total Investment 11.11% =B26/$B$21 36 Common Equity Stock % of Total Investment 51.85% =B28/$B$21 37 WACC 9.88% =(B34*B25)+(B35*B27)+(B36*B29) 38

WACC of the project = 9.88%