Question

Kuhn does not have any retained earnings available to finance this project, so the firm will have to issue new common stock to help fund it. Its common stock is currently selling for $33.35 per share, and it is expected to pay a dividend of $2.78 at the end of next year. Flotation costs will represent 8% of the funds raised by issuing new common stock. The company is projected to grow at a constant rate of 8.7%, and they face a tax rate of 25%. What will be the WACC for this project

Answer 1

Answer:

Flotation costs increase the cost of equity:

since Kuhn only receives $0.92 per every dollar of common stocks, cost of equity increases by $0.08 / $0.92 = 8.7%

cost of equity without issuing additional common stocks:

$33.35 = $2.78 / (Re - 8.7%)

Re - 8.7% = $2.78 / $33.35 = 8.34%

Re = 8.34% + 8.7% = 17.04%

since the project is going to be financed solely by issuing common stocks, its WACC = 17.04% x (1 + 8.7%) = 18.52%

if the company also issued debt or preferred stocks in order to finance this project, the project's WACC would probably decrease. Generally, equity is much more expensive than debt. That means that a project that is solely financed through equity will have a high WACC: