Chapt 7. Solving for the WACC The weighted average cost of capital (WACC) is used as...

Transcribed Image Text:

Chapt 7. Solving for the WACC 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%. If its current tax rate is 40%, Turnbull's weighted average cost of capital (WACC) will be 0.64% capital by issuing new common stock instead of raising the funds through retained earnings. higher if it has to raise additional common equity Turnbull Company is considering a project that requires an initial investment of $570,000.00. The firm will raise the $570,000.00 in capital by issuing $230,000.00 of debt at a before-tax cost of 8.70 %, $20,000.00 of preferred stock at a cost of 9.90%, and $320,000.00 of equity at a cost of 13.20%. The firm faces a tax rate of 40%. The WACC for this project is Grade It Now Save & Continue Continue without saving Chapt 7. Solving for the WACC 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%. If its current tax rate is 40%, Turnbull's weighted average cost of capital (WACC) will be 0.64% capital by issuing new common stock instead of raising the funds through retained earnings. higher if it has to raise additional common equity Turnbull Company is considering a project that requires an initial investment of $570,000.00. The firm will raise the $570,000.00 in capital by issuing $230,000.00 of debt at a before-tax cost of 8.70 %, $20,000.00 of preferred stock at a cost of 9.90%, and $320,000.00 of equity at a cost of 13.20%. The firm faces a tax rate of 40%. The WACC for this project is Grade It Now Save & Continue Continue without saving