Fin 515 Week 4 Homework Assignment

Miller Manufacturing has a target debt–equity ratio of .65. Its cost of equity is 13 percent, and its cost of debt is 9 percent. If the tax rate is 40 percent, what is the company’s WACC? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

General speaking, WACC is the rate that a company’s shareholders expect to be paid on average to finance its assets, and it is the overall required return on the firm as a whole. Therefore, company directors often use WACC to determine whether a financial decision is feasible or not. In this case, I will choose 9.38% as discount rate. The reason why I choose 9.38% as discount rate is because the estimated Debt/Equity is 26% under the assumptions by CFO Sheila Dowling, which is most close to 25% of Debt/Equity from the projected WACC schedule. There might be some flaws existing by using WACC as discount rate. As we know, the cost of debt would be raised significantly as the leverage increased. The investment will definitely increase the firm’s current debt. So, the cost of debt would not keep at 7.75%.

To relever the βe, we use the formula, βe = βu +(D/E)*(βu-βd). And the “Target D/E” was found by taking “Target D/V” divided by “1-Target D/V”. So we get the new βe, 1.3576. Then to get cost of equity, we use the CAPM formula, Re=Rf+β(EMRP), 11.7679%. Since we have get the cost of equity and cost of debt, we can determined the WACC, which is equal to Equity/Value*Cost of Equity+Debt/Value*Cost of Debt*(1-tax rate). In the end ,we arrived at 8.48%.

We assume that risk free rate (Rf) equals rate of long-term Treasury Bonds (as the project’s life is 10 years), so Rf = 9.5%.

Weighted Average Cost of Capital (WACC) is the combined rate at which a company repays borrowed capital and comes from debit financing and equity capital. WACC can be reduced by cutting debt financing costs, lowering equity costs, and capital restructuring. In order to minimize WACC, companies can issue bonds by lowering the interest rate they offer to investors as well as, cutting down

WACC= (%of debt) (after-tax cost of debt) + (% of preferred stock)(Cost of preferred stock) + (% of common equity) (Cost of common equity)

RE = [$1.30 × (1 + 0.060)] / $36.80 + 0.060 = 0.097446 = 9.74 percent (3)

In order to find the WACC, we need to find the cost of the components of the capital structure and their proportion in the total capital.

Moreover, let’s calculate the Weighted Average Cost of Capital (WACC). And in order to calculate it we need to know the capital structure of the company. Knowing the capital structure of the

WACC = (1-corporate tax rate)(Pretax rate of cost of debt)(Market value of debt/ D+E))+ After tax rate of cost of equity(market value of equity/D+E))

Thus the WAVG Cost of Debt (including L/T debt and preferred stock) = rd = 8.633%

company’s securities, both debt and equity. The WACC is important to calculate because it is a necessary

WACC calculations entailed several different steps prior to using the actual WACC formula. First, by using CPP’s balance sheet we identified its D/E, by dividing Debt portion by the Equity portion arriving at 2.07, than we calculated D/V – 0.67 and E/V – 0.33. Afterwards, we used comparable firm Wackenhut’s capital structure for our analysis and applied it to our calculations. Wackenhut’s capital structure consisted of 92% equity and 8% debt. Subsequently, we went through the Beta unlevering and then levering process using above capital structure. To unlever, we multiplied given beta of 0.89 by the debt portion of capital structure 0.92, than we relevered the Beta_e=(1+D/E 2.07) * unlevered Beta 0.82 = 2.51. Next step consisted of calculating R_e=R_f+beta_e*MRP= 8.6%(given)+2.51*7.5% (given)=27.41%.

Kd (Wd), Ke (We) and Kp (Wp) are the costs (weights) associated, respectively, with the firm’s interest bearing debt,

All of these calculated figures can then be used to calculate the WACC which is (17% x 3.47%) + (83% x 11.2%) = 9.87% WACC. This WACC percentage can then be used to value the investment and as a comparative in valuation methods. The full calculation and numerical values are shown in Appendix 1.