Question

Consider the case of Kuhn Corporation.

Kuhn Corporation is considering a new project that will require an initial investment of $45,000,000. It has a target capital structure consisting of 35% debt, 2% preferred stock, and 63% common equity.

Kuhn has noncallable bonds outstanding that mature in 15 years with a face value of $1,000, an annual coupon rate of 11%, and a market price of $1,555.38. 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 $9.00 at a price of $95.70 per share.

Kuhn Corporation 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 $33.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 8.00% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 9.20%, and they face a tax rate of 40%.

Kuhn Company’s WACC for this project will be _________ .

a. 11.45%

b.12.72%

c. 10.18%

d. 12.08%

Answer 1

Weighted average cost of capital=(weight of equity*cost of equity)+(weight of preferred stock*cost of preferred stock)+(weight of debt*after tax cost of debt)

weight of equity=63%

Weight of preferred stock=2%

Weight of debt=35%

before tax cost of debt=Yield of a bond

Yield of debt can be found by RATE function in EXCEL

=RATE(nper,pmt,pv,fv,type)

pmt=11%*1000=110

nper=15 years

=RATE(15,110,-1555.38,1000,0)

=5.48%

Before tax cost of debt=5.48%

After tax cost of debt=before tax cost of debt*(1-tax rate)=5.48%*(1-40%)=3.2%

Cost of preferred stock=annual dividend/preferred share price=9/95.7=9.40%

Cost of equity=(Dividend next year /((Share price*(1-flotation cost))+g

=($2.78/(33.35*(1-8%))+9.20%

=18.2%

Weighted average cost of capital=(63%*18.2%)+(2%*9.4%)+(35%*3.2%)=12.7%

Option B is correct