Question

Larry Larson has proposed that HopHeart Brewery expand their bottling facility. His proposal will bring in a lot of new revenue. If the company goes forward with his plan, they will generate funds with a mix of 50% bonds paying 8.0%/year. 25% bank loans at 8% per year, and 25% preferred stock with a $9.60 dividend each year The stock will sell for $100 per share. The company is heavily taxed, and pays 45% on all of its net income. What is the WACC?  %

HopHeart only approves Projects that return 6% above their WACC. What MARR must Larry show the board in order to get his project approved?

Answer 1

While calculating WACC, you should take the after tax cost of debt as would get tax benefits on the interest payments of debt.

Pre - tax cost of debt = 8%

After - tax cost of debt = Pre - tax cost of debt x (1 - tax rate) = 8% x (1 - 0.45) = 4.4%

Cost of preferred stock = Dividend / stock price = $9.60 / $100 = 0.096 or 9.6%

Now, weight of debt in the capital structure = 50% + 25% = 75% or 0.75, Weight of preferred stock = 25% or 0.25

WACC = After - tax cost of debt x Weight of debt + Cost of preferred stock x Weight of preferred stock

or, WACC = 4.4% x 0.75 + 9.6% x 0.25 = 5.70%

Therefore, Larry must show a MARR = 6% + WACC = 6% + 5.70% = 11.70%