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WACC: Capital Structure and Equity

On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt.

Debt $30,000,000
Common Equity 30,000,000
Total capital $60,000,000

New bonds will have an 8 percent coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. Stockholder's required rate of return is estimated to be 12 percent, consisting of a dividend yield of 4 percent and an expected constant growth rate of 8 percent. (The next expected dividend is $1.20, so $1.20/$30 = 4%.) The marginal corporate tax rate is 40 percent.

a. To maintain the present capital structure, how much of the new investment must be financed by common equity?

b. Assume that there is sufficient cash flow such that Tysseland can maintain its target capital structure without issuing additional shares of equity. What is the WACC?

c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC?

Solution Preview

On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm's present market value capital structure, shown below, is considered to be optimal. Assume that there is no short-term debt.

Debt $30,000,000
Common Equity 30,000,000
Total capital $60,000,000

New bonds will have an 8 percent coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. Stockholder's ...

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$2.19