I'm stuck on the following WACC problem and need a little help. Please show all steps and formulas.
Copernicus Inc. has determined that its target capital structure will be 60% debt, 10% preferred stock, and 30% common stock. As the financial manager, the CFO has informed you that the company's before tax cost of debt is 10%, preferred stock is 14%, and common stock is 16%. In addition, the company's marginal tax rate is 40%. Based on the information provided, calculate the weighted average cost of capital (WACC).© BrainMass Inc. brainmass.com December 19, 2018, 8:47 pm ad1c9bdddf
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Your question seems to be lacking some of the necessary information for many of the more complicated equations for calculating WACC. However, I found a simple example, that seems to fit your given information in your question, so we will look at that first:
1. To understand WACC, think of a company as a bag of money. The money in the bag comes from two sources: debt and equity. Money from business operations is not a third source because, after paying for debt, any cash left over that is not returned to shareholders in the form of dividends is kept in the bag on behalf of shareholders. If debt holders require a 10% (10%) return on their investment and shareholders require a 20% (10% + 14% = 30%) return, then, on average, projects funded by the bag of money will have to return 15% to satisfy debt and equity holders. The 15% is the WACC. (The WACC is 20%) http://www.investopedia.com/articles/fundamental/03/061103.asp
In line with this example, then, for the Copernicus Inc. WACC = 20% as shown in the red in the above example. Calculations shown in red are for your question and how they are similar to this question. A: WACC = 20%
Now let's look at the more complicated equations and what the information required (that is not a given in your question) in order to use these equations:
2. The WACC is represented by the following formula:
WACC = Re x E/V (Not given in your question, and show how to calculate in #5 below) + Rd x (1 - corporate tax rate) x D/V
See http://www.investopedia.com/articles/fundamental/03/061103.asp for explanation of each variable.
3. WACC = Debt/TF (cost of debt) (1-tax) + Equity / TF (cost of equity)
In this formula,
*TF means total financing. Total financing consists of the Market values of debt and equity finance. An issue is whether, and under what circumstances it should include current liabilities, such as trade credits. In valuing a company that is important, because, (a) trade credit is used aggressively by many companies, (b) there is an interest or financing charge for such use, and (c) trade credit can be quite a large sum on the balance sheet.
* Tax stands for corporate tax rates
Example (in black and the red is information equivalents from your question above): Suppose this company:
The market value of debt = 300 million (? - need to calculate this for your question, see number 5 below how to do these calculations)
The market value of equity = 400 million (? - need to calculate this for your question, see #5 also)
The cost of debt = 8% (10%)
The corporate tax rate = 35% (40%)
The cost of equity = 18% (30%=14%+16%)
The WAAC of the example company is:
Debt/TF (cost of debt) (1-tax) + Equity / TF (cost of equity) = WACC
300/700(8%) (1-35%) + 400/700(18%) = 12.5% WACC (http://www.valuebasedmanagement.net/methods_wacc.html).
Your question using equation 3:
Debt/TF (10%) (1-40%) + Equity/TF (30%) = WACC
Next step, you would need to calculate the market value of debt and market vale of equity. Do we have enough information? (See #5 below for ways to calculate these figures)
4. A firm's weighted average cost ...
This solution provides various equations to calculate the WACC problem and the solution.