Wayne State CollegeBUS 608

Kuhn Co. is considering a new project that will require an initial investment of $45 million. It has a target capital structure of 35% debt, 2% preferred stock, and 63% common equity. Kuhn has noncallable bonds outstanding that mature in five years with a face value of $1,000, an annual coupon rate of 10%, and a market price of $1,050.76. The yield on the company's current bonds is a good approximation of the yield on any new bonds that it issues. The company can sell shares of preferred stock that pay an annual dividend of $8 at a price of $95.70 per share. You can assume that Jordan does not incur any flotation costs when issuing debt and preferred stock.

Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $22.35 per share, and it is expected to pay a dividend of $1.36 at the end of next year. Flotation costs will represent 3% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 9.2%, and they face a tax rate of 40%. Determine what Kuhn Company's WACC will be for this project.     

Answer:

Kuhn Company's WACC for the project will be=11.74

Step-by-step explanation

(I) The weight of the capital components of the capital structure 

Debt= 0.35 

Common Equity = 0.63

Preferred Equity =0.02

(II) Costs of the capital sources 

Debt

The pretax cost of debt is the yield to maturity on the bonds. It is calculated using either the approximation method or Excel^TM Rate function. 

Using approximation method

Yield to maturity = ( Coupon paid + ( Face value - Price) / Year to maturity))/ ( Face value + Current price )/ 2 

Yield on the bonds = ( 100+ (1000-1050.76) / 5 ))/ (2050.76)/2

Approximate YTM = 89/1025.38=8.7%

Using Excel Rate function 

=RATE ( NPER, PMT, PV, FV)

=RATE(5,100,-1050.76, 1000)

We get

The yield on the company's current bonds=8.70%

After tax cost of debt = Yield * (1-tax rate) =8.70% * (1-0.40)=5.22%

Common Equity 

Using the constant growth model 

• Cost of new common equity = Expected dividend / Net proceeds + Growth rate 

Cost of new common equity = 1.36/ 22.35 *(1-0.03) + 0.092

Cost of new common equity = 1.36/21.6795+0.092=15.4732%

Preferred equity 

Cost of preferred equity = Annual dividend / Current price =8/95.7=8.3595%

Lastly, the WACC is calculated as:

• Weighted cost of capital = Weight of debt * After tax cost of debt + Weight of common equity * Cost of common equity + Weight of preferred stock * Cost preferred stock 

Kuhn Company's WACC for the project will be =(0.35*5.22%) +(0.63*15.4732%)+(0.02*8.3595%)=11.74%