Question

Turnbull Co. is considering a project that requires an initial investment of $570,000. The firm will raise the $570,000 in capital by issuing $230,000 of debt at a before-tax cost of 10.2%, $20,000 of preferred stock at a cost of 11,4%, and $320,000 of equity at a cost of 14.3%. The firm faces a tax rate of 40%. What will be the WACC for this project?

a. 10.89%
b. 7.62%
c. 12.52%
d. 8.71%

Answer 1

To calculate the WACC for Turnbull Co., we compute the weighted costs of debt, preferred stock, and equity based on their proportions in the capital structure. After adjusting for taxes, these costs are added together to get a WACC of 10.89%.

Step-by-step explanation:

The question pertains to calculating the Weighted Average Cost of Capital (WACC) for Turnbull Co., which is considering a project that requires an investment of $570,000 financed through a mix of debt, preferred stock, and equity. To calculate WACC, we need to multiply the cost of each component by its proportion in the overall financing, adjusting the cost of debt to reflect the tax savings from interest expense as follows:

• Cost of Debt after taxes = before-tax cost of debt * (1 - tax rate) = 10.2% * (1 - 40%) = 6.12%
• Proportion of Debt = $230,000 / $570,000 = 40.35%
• Weighted Cost of Debt = 6.12% * 40.35% = 2.47%
• Cost of Preferred Stock = 11.4%
• Proportion of Preferred Stock = $20,000 / $570,000 = 3.51%
• Weighted Cost of Preferred Stock = 11.4% * 3.51% = 0.40%
• Cost of Equity = 14.3%
• Proportion of Equity = $320,000 / $570,000 = 56.14%
• Weighted Cost of Equity = 14.3% * 56.14% = 8.02%

Adding these up gives us the WACC:

WACC = Weighted Cost of Debt + Weighted Cost of Preferred Stock + Weighted Cost of Equity = 2.47% + 0.40% + 8.02% = 10.89%

Therefore, the correct answer is a. 10.89%