Principles of Finance for the Private Sector

1 Principles of Finance for the Private Sector WACC = (Cost of Debt)* (Weight of debt)*(1-Tax Rate) + (Cost of preferred stock)*(Weight of Preferred Stock) + (Cost of Common Stock)*(Weight of Common Stock) Weight of Debt = (Total debt)/(Total Debt + Total Preferred Stock + Total Common Stock) Weight of Preferred Stock = (Total Preferred Stock)/(Total Debt + Total Preferred Stock + Total Common Stock) Weight of Common Stock = (Total Common Stock)/(Total Debt + Total Preferred Stock + Total Common Stock) Considering the following information; Cost

Value

Weight

Tax rate

Debt

6.5%

$400000

42.11%

40%

Preferred stock

7.25%

$50000

5.26%

Common stock

11%

$500000

52.63%

WACC = 6.5%*(400,000/950,000)*(1-40%)+7.25%*(50,000/950,000)+11%*(500,000/950,000) = 7.8132%\

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2 Total Funds available = $950,000 Used Funds = $850,000 Available for usage = $950,000-$850,000 = $100,000 Required Funds for the new Project = $250,000 Additional Funds required = $250,000 - $100,000 = $150,000 Expected Return on the project = 13.5%

(A) Since the Expected Return on the project is greater than the WACC of the company, the project should be taken up by the company.

Debt is the cheapest form of funds available to raise (6.5%) when compared to the Preferred Stock of 7.25% and Common Stock of 11%.

(B) To fund the additional amount of $150,000 required, the firm should raise funds by taking Long term Debt.

New WACC, with an additional $150,000 raised through debt, will be based on the following parameters.

Cost

Value

Weight

Tax rate

Debt

6.5%

550000

50%

40%

Preferred stock

7.25%

50,000

4.55%

Common stock

11%

500,000

45.45%

New WACC = 6.5 %*(550,000/1,100,000)*(1-40%) + 7.25%*(50,000/1,100,000) + 11%*(500,000/1,100,000) = 7.2795% If Preferred Stock is used, the WACC would depend on the following parameters:

3 Cost

Value

Weight

Tax rate

Debt

6.5%

400000

36.36%

40%

Preferred stock

7.25%

200000

18.18%

Common stock

11%

500000

45.45%

WACC = 6.5%*(400,000/1,100,000)*(1-40%) +7.25%*(200,000/1,100,000)+11%*(500,000/1,100,000) = 7.7364% If Common Stock is used, the WACC would depend on the following parameters: Cost

Value

Weight

Tax rate

Debt

6.5%

400,000

36.36%

40%

Preferred stock

7.25%

200,000

18.18%

Common stock

11%

500,000

45.45%

WACC = 6.5%*(400,000/1,100,000)*(1-40%) +7.25%*(50,000/1,100,000)+11%*(650,000/1,100,000) = 8.2477% From the above analysis, the WACC would change as follows with the three ways of funding the additional amount required : Original WACC

7.8132%

Debt funding

7.2795%

Preferred stock funding

7.7364%

Common stock funding

8.2477%

From the analysis, it can be concluded that Debt funding will be the best way to source the funds that are required for the project. However, the company should also note that as debt

4 weight increases, the cost of raising the debt will also be on the rise, and try to control the level of debt with time (Melicher & Norton, 2013).

5 Reference Melicher, R. W., & Norton, E. A. (2013). Introduction to finance: markets, investments, and financial management. John Wiley & Sons.