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Financial Management: Component Costs of Capital/WACC

In the attached document is the Acme Manufacturing Company's abbreviated Balance Sheet for the current fiscal year. In addition, data is listed for three projects that management is evaluating for possible acceptance for this year.

1. What are the component costs of capital for Acme's existing capital? (For the common stock component, do all three methods)

2. If Acme were to raise capital using bonds, what bond rating do you think is likely for Acme's second bond? (Use Table 1.) What yield would investors require for this second bond (rd)? (Use Table 2.)

3. If Acme were to raise capital using common stock, what yield would investors require? What would be the re, therefore, to Acme?

4. If Acme were to keep approximately the same debt ratio and raises all of the new capital externally, what is Acme's WACC and the resulting debt ratio? Using this WACC and risk adjusting as appropriate, what is each project's NPV, IRR, MIRR and PI?


Solution Preview

We have,

Cost of Common Stock:
Given that,
Beta of Acme Stock=1.20
Long term Stock market return=7%
10-year Treasury yield=2.74%
Long term bond market return=4%
Risk premium=7%-2.74%=4.26%
Using CAPM Method:
Cost of Equity=2.74%+4.26%*1.20=7.85%

Using Bond Yield plus Risk Premium Method:
Cost of Equity=4.26%+4%=8.26%
As the company do not pay dividend we can't use the dividend discount model to calculate the cost of equity for the firm.

Cost of Debt:
Bond Rating Ratios for Acme:
Operating Profit Margin Ratio=(Operating Income)/(Net Revenue)=$2,000,000/$22,000,000=9.09%
TIE Ratio=(Operating Income)/(Interest Expenses)=$2,000,000/$260,000=7.69
Fix Charge Coverage ...

Solution Summary

The component costs of capital for WACC financial management are discussed.