Coogly Company: Calculating And Analyzing WACC For Strategy

Coogly Company: Calculating and Analyzing WACC for Strategic Investment Decisions

Coogly Company is attempting to identify its weighted average cost of capital (WACC) for the coming year and has hired you to answer some questions they have about the process. The company would like for you to present this information in a PowerPoint presentation to the management team. The presentation should be approximately 10 slides, with notes explaining each point. Your presentation must address specific questions, including the component costs of different capital sources, the overall WACC calculation, and a discussion of the advantages and disadvantages of each financing method as well as the WACC approach in capital budgeting. Additionally, include relevant visuals such as graphs or charts to aid understanding and support your analysis with credible sources.

Paper For Above instruction

Introduction

Understanding the weighted average cost of capital (WACC) is fundamental for corporate finance decisions, especially in capital budgeting and investment analysis. WACC represents the average rate a company expects to pay to finance its assets through equity, preferred stock, and debt, weighted by their respective proportions in the overall capital structure. For Coogly Company, identifying this rate allows strategic assessment of investment opportunities and capital allocation. This paper details the calculation of each component's cost, discusses the advantages and disadvantages of each financing source, and presents the final WACC figure, emphasizing the practicalities and considerations of employing WACC in corporate financial decisions.

Component Cost of Preferred Stock

Preferred stock costs are calculated based on the dividend paid and net issuing costs. The dividend per share is $4, and the preferred stock sells at $82 with a flotation cost of $6 per share. The net proceeds per share after flotation costs are $76 ($82 - $6). The component cost of preferred stock (Kp) is thus:

Kp = Dividend / Net Proceeds = $4 / $76 ≈ 5.26%

Advantages of using preferred stock include its fixed dividend payments, which provide predictability for investors, and its priority over common equity in dividend payments. However, disadvantages include the fixed cost burden regardless of company profitability and its impact on earnings per share. Preferred stock also may be less flexible as dividends are often cumulative, creating potential cash flow strains.

Cost of New Common Equity

The company plans to issue new equity at $50 per share, with flotation costs of $9, last dividends paid at $3.80, and a growth rate of 7%. The cost of equity (Ke) using the dividend growth model (Gordon Growth Model) is:

Ke = (D1 / P0) + g = ($3.80 × 1.07) / ($50 - $9) + 0.07

Calculated as:

D1 = $3.80 × 1.07 = $4.07

P0 = $50

Net proceeds per share after flotation costs: $41 ($50 - $9)

Ke = $4.07 / $41 + 0.07 ≈ 0.10 + 0.07 = 17%

The advantages of issuing new equity include the permanent increase in capital without incurring debt obligations, and it avoids interest payment commitments. Disadvantages are dilution of existing shareholders' ownership, and the higher cost relative to debt, which may raise WACC, and possible negative perceptions from the market regarding equity issuance.

Cost of New Debt

The firm plans to issue bonds with a face value of $1000, coupon rate of 6%, flotation costs of 7%, and a maturity of 20 years. The cost of debt (Kd) must be adjusted for flotation costs and calculated as the yield to maturity (YTM) estimate. The approximate cost before flotation costs is:

Yield approximates the coupon rate plus the premium/discount adjusted for price:

Considering flotation costs, the net proceeds per bond are $930 ($1000 - 7%).

Using the YTM formula or a financial calculator, the approximate cost of debt (before taxes) is around 6.5%. Adjusting for the tax shield (since interest is tax-deductible) at 40% tax rate, the after-tax cost is:

Kd = 6.5% × (1 - 0.40) ≈ 3.9%

Advantages of issuing new debt include generally lower costs due to tax deductibility, and the preservation of ownership structure. Disadvantages involve the obligation to make fixed interest payments, which can strain cash flows, and increased financial risk during downturns or when leveraging the company’s balance sheet.

Calculating the WACC and Discussing Its Use

Given costs and capital structure proportions:

- Preferred stock: 10%

- Debt: 30%

- Equity: 60%

And component costs:

- Preferred stock: ≈ 5.26%

- Debt (after taxes): ≈ 3.9%

- Equity: 17%

The WACC is calculated as:

WACC = (E/V) × Ke + (P/V) × Kp + (D/V) × Kd × (1 - Tax rate)

where:

  • E/V = 0.60
  • P/V = 0.10
  • D/V = 0.30
  • Tax rate = 40%

Plugging in the values:

WACC = 0.60 × 17% + 0.10 × 5.26% + 0.30 × 3.9% × (1 - 0.40) ≈ 10.2% + 0.526% + 0.70% ≈ 11.43%

This weighted average provides a discount rate for evaluation of future projects, balancing cost considerations of various funding sources.

Advantages and Disadvantages of WACC in Capital Budgeting

The primary advantage of using WACC is that it encapsulates the overall risk profile and cost structure of the firm, providing a benchmark for investment decisions and capital allocation. It helps in assessing whether a project adds value by comparing its expected return to the firm’s WACC. However, disadvantages include its sensitivity to assumptions, such as fluctuating market conditions affecting component costs, and the static nature that might not reflect real-time risk changes. Moreover, WACC might oversimplify the risk differential across different projects, leading to suboptimal investment choices if not adjusted appropriately.

Conclusion

Integrating the component costs of preferred stock, equity, and debt with the firm's targeted capital structure yields a comprehensive WACC of approximately 11.43%. This rate is instrumental in evaluating capital investment projects and guiding strategic financing decisions. While the WACC approach offers significant advantages in aligning investment returns with company costs, it must be applied judiciously, considering market volatility and project-specific risks. The judicious use of WACC in capital budgeting enables Coogly to optimize its value creation trajectory while maintaining financial stability and competitiveness.

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