The Expanding Capital Corporation has a current capital structure of $15 million in secured bonds paying 6.5% annual interest, $10 million in preferred stock with a par value of $50 per share and an annual dividend of $3.80 per share, and common stock with a book value of $75 million. It is about to issue new debentures in the amount of $10 million paying 7.5% annual interest. Its CFO says its marginal tax rate is 30% and its cost of common equity capital is 12%. Calculate the company’s Weighted Average Costs of Capital for the following:
In this essay, we will explore how to calculate the Weighted Average Cost of Capital (WACC) for Expanding Capital Corporation, a hypothetical company with a diversified capital structure. WACC is a crucial financial metric that helps companies determine the minimum return they need to generate from their investments to satisfy their investors and creditors. By understanding the WACC, companies can make informed decisions about raising capital for their projects. We will calculate the WACC for Expanding Capital Corporation before and after issuing new debentures, taking into account the current capital structure and proposed changes.
To calculate the WACC before the new bond issue, we need to consider the existing capital structure of Expanding Capital Corporation, which consists of secured bonds, preferred stock, and common stock. Each component’s weight is determined by its proportion in the company’s total capital.
Amount of secured bonds = $15 million
Interest rate on secured bonds = 6.5%
Tax rate = 30%
The after-tax cost of debt can be calculated using the formula:
After-tax cost of debt = Interest rate on secured bonds * (1 – Tax rate)
After-tax cost of debt = 6.5% * (1 – 0.30) = 4.55%
Amount of preferred stock = $10 million
Annual dividend per share = $3.80 per share
Par value per share = $50 per share
The cost of preferred stock can be calculated using the formula:
Cost of preferred stock = Annual dividend per share / Par value per share
Cost of preferred stock = $3.80 / $50 = 0.076 or 7.6%
Book value of common stock = $75 million
Cost of common equity capital = 12%
The cost of common equity can be directly used as the cost of common stock:
Cost of common stock = 12%
Now, let’s calculate the Weighted Average Cost of Capital (WACC) before the new bond issue:
WACC = (Weight of secured bonds * After-tax cost of debt) + (Weight of preferred stock * Cost of preferred stock) + (Weight of common stock * Cost of common stock)
WACC = (15 / 100) * 4.55 + (10 / 100) * 7.6 + (75 / 100) * 12
WACC = 0.6825 + 0.76 + 9
WACC = 10.4425%
After the new bond issue
Expanding Capital Corporation is about to issue new debentures in the amount of $10 million with an annual interest rate of 7.5%.
Amount of new debentures = $10 million
Interest rate on new debentures = 7.5%
Tax rate = 30%
The after-tax cost of new debt can be calculated in the same way as before:
After-tax cost of new debt = Interest rate on new debentures * (1 – Tax rate)
After-tax cost of new debt = 7.5% * (1 – 0.30) = 5.25%
Now, let’s calculate the WACC after the new bond issue:
WACC = (Weight of secured bonds * After-tax cost of debt) + (Weight of preferred stock * Cost of preferred stock) + (Weight of common stock * Cost of common stock) + (Weight of new debentures * After-tax cost of new debt)
WACC = (15 / 100) * 4.55 + (10 / 100) * 7.6 + (75 / 100) * 12 + (10 / 100) * 5.25
WACC = 0.6825 + 0.76 + 9 + 0.525
WACC = 10.9675%
In conclusion, we have calculated the Weighted Average Cost of Capital (WACC) for Expanding Capital Corporation before and after the new bond issue. Before the new bond issue, the WACC was 10.4425%, and after the new bond issue, it increased to 10.9675%. The WACC represents the company’s blended cost of all sources of financing and serves as a useful metric for making financial decisions. Companies can use the WACC as a benchmark to assess the feasibility of new projects, with those projects needing to generate returns higher than the WACC to be considered worthwhile. It is essential for Expanding Capital Corporation to keep monitoring its WACC regularly and make necessary adjustments to maintain optimal capital structure and overall financial health.
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