Deck 8: Capital Structure and the WACC

Question 1

Explain in your own words the logic of using the weighted average cost of capital as the discount rate for capital projects.

Answer 1

The WACC calculates the percentage cost to the firm for using money from all sources, internal and external. The component cost for each source is calculated as the required return to the investor, including any tax effects or flotation costs. The overall cost is a weighted average of the component costs, with the weights calculated as the percentage of invested money from each source divided by the total amount of money invested in the firm. Thus, the overall cost takes into account not only how much it costs for each source of funds, but how much use is made of each source of funds.

Question 2

List the component costs of capital in ascending order (all four of them). Justify your ranking with an explanation for each component cost.

Answer 2

For most firms, k_d(1 − T) < k_p < k_e < k_n. Debt has the lowest component cost for two reasons: the bondholders are protected by the bond contract, making debt the least risky source of funds, and the tax break the firm receives for borrowing funds lowers the effective cost. The cost of new preferred equity may approach the cost of retained earnings, but since preferred dividends must be paid before common dividends may be paid, and since the preferred shareholders have a higher claim against assets than the common shareholders in the case of bankruptcy, preferred equity is less risky, and therefore less costly, than retained earnings. New common equity will be the most expensive because it includes the cost of retained earnings as well as flotation costs for issuing new securities.

Question 3

Calculate the after-tax cost of debt for firms with the following yields to maturity for their new bonds. Assume the firm's marginal tax rate is 25.00%.
a. YTM = 6.40%
b. YTM = 7.80%
c. YTM = 9.90%
Repeat parts a-c using a marginal tax rate of 35.00%. What effect does raising the tax rate have on the component cost of debt?

Answer 3

a. k_d(1 − T) = 6.40(.75) = 4.80%
b. k_d(1 − T) = 7.80(.75) = 5.85%
c. k_d(1 − T) = 9.90(.75) = 7.43%
d. k_d(1 − T) = 6.40(.65) = 4.16%
e. k_d(1 − T) = 7.80(.65) = 5.07%
f. k_d(1 − T) = 9.90(.65) = 6.44%
Raising the tax rate lowers the component cost of debt-the tax break for borrowing money is greater.

Question 4

Tandem Industries can sell new shares of preferred stock for $28.00 per share, but flotation costs will run them $1.00 per share. Tandem's preferred stock currently pays a $3.00 dividend. What is the component cost for Tandem's new preferred equity?

Question 5

Your boss is the treasurer of the company, and she expects the firm will grow at 4.00% annually in the future. She also believes that issuing bonds is less expensive than the cost of retained earnings. Your firm's debt securities have a yield to maturity of 8.50%, and the firm's marginal tax rate is 30.00%. The current market price of your firm's common stock is $19.00, and the annual dividend expected next year is $1.50 per share.
Calculate the component costs of both debt and retained earnings to see if your boss is right.

Question 6

Empire Capital Enterprises has a beta of 1.36. The current yield on 10-year US T-notes is 4.25%, and the return to the S&P 500 index fund is 9.60%. Given these data, what is Empire's cost of retained earnings?

Question 7

Gallagher Industries' common stock currently sells for $20.00 per share. The common dividend just paid was $1.20, and the dividend is expected to increase at a rate of 5% annually. Floating new common shares will cost Gallagher 5% of the market price of the stock. What is Gallagher's component cost of new common equity?

Question 8

Newman International has an optimal capital structure that consists of 35.00% debt, 15.00% preferred equity, and 50.00% common equity. Their new bond issue will have a coupon rate of 7.20%. Their preferred stock currently sells for $40 per share, and floating new shares would cost $2.00 per share. The preferred dividend is fixed at $2.60 annually. Newman's common stock has a current market price of $33.00, and floating new common shares would cost Newman 6.00% of the share price. The most recent annual common dividend paid was $2.50, and the dividend is expected to grow at an annual rate of 5.00%. The firm's marginal tax rate is 30.00%. Use these data to calculate Newman's WACC using both retained earnings and new common equity.

Question 9

The most recent data for Harper Housewares is given below:
What are Harper's weights for debt, common equity and preferred equity?

Question 10

Daytona Dairies has preferred stock that pays a dividend of $3.25. Their preferred stock currently sells for $34.21. Flotation costs for new preferred stock are expected to be 5% of the share price. What is the component cost of Daytona's preferred equity?

Question 11

T-notes are currently paying 5.5%, while the S&P 500 is paying 8%. Sentry Electronics has a beta of 1.5. What is the component cost of Sentry's retained earnings?

Question 12

Fairweather Pharmacies' component costs of capital and their weights are given below:
k_d = 10% w_d = 45%
k_p = 5% w_p = 10%
k_e = 8% w_e = 45%
T = 40%
Given these figures, what is Fairweather's weighted-average cost of capital?

Question 13

Anspagh Automobiles just paid a common dividend of $2.50 at the end of last year, and that dividend is expected to grow at an annual rate of 10%. Their common stock currently sells for $101.85, which is what they expect to get for newly issued shares at this time. Flotation costs on newly issued shares are 5% of the stock price. What is Anspagh's component cost of new equity?

Question 14

The CEO of Harlem Hardware Supplies has submitted together a capital budget of $48,500,000 for the following year's investment opportunities. He expects to have $19,000,000 in retained earnings at the end of the year. Harlem's target capital structure calls for 45 percent equity. Based on these figures, will Harlem be able to meet their capital budget needs with retained earnings?