Coogly Company's Weighted Average Cost Of Capital Analysis

Coogly Company's Weighted Average Cost Of Capital Analysis and Presentation

Coogly Company is attempting to identify its weighted average cost of capital for the coming year and has hired you to answer some questions they have about the process. They have asked you to present this information in a PowerPoint presentation to the company’s management team. The company would like for you to keep your presentation to approximately 10 slides and use the notes section in PowerPoint to clarify your point. Your presentation should address the following questions and offer a final recommendation to Coogly. Make sure you support your answers and clearly explain the advantages and disadvantages of utilizing the weighted average cost of capital methodology.

Include at least one graph or chart in your presentation. Company Information: The capital structure for the firm will be maintained and is now 10% preferred stock, 30% debt, and 60% new common stock. No retained earnings are available. The marginal tax rate for the firm is 40%. Coogly has outstanding preferred stock that pays a dividend of $4 per share and sells for $82 per share, with a floatation cost of $6 per share. If the company issues new common stock, it will sell for $50 per share with a floatation cost of $9 per share. The last dividend paid was $3.80, and this dividend is expected to grow at a rate of 7% for the foreseeable future. The bonds used for capital projects will have a market and par value of $1000, with a coupon rate of 6% and a floatation cost of 7%. The bonds will mature in 20 years, and no other debt will be used for new investments. Based on this information, you are to compute each component cost (preferred stock, equity, debt), and then calculate the firm's weighted average cost of capital (WACC). Finally, evaluate the advantages and disadvantages of each component and of the overall WACC approach in capital budgeting.

Paper For Above instruction

The task of determining a company's weighted average cost of capital (WACC) is a fundamental aspect of corporate finance, serving as a critical benchmark in investment decision-making and capital budgeting. For Coogly Company, understanding the individual costs of preferred stock, common equity, and debt—as well as their weighted contribution based on the company's capital structure—is essential in estimating an accurate WACC to guide future projects and strategic decisions.

Cost of Preferred Stock

The component cost for preferred stock is calculated using the formula:

Preferred Stock Cost (Kps) = Dp / (Pp - Fp)

Where Dp is the annual dividend, Pp is the current price, and Fp is the floatation cost per share.

Given that Dp = $4, Pp = $82, and Fp = $6, the net issuance price is $82 - $6 = $76.

Therefore, the preferred stock cost:

Kps = $4 / $76 ≈ 5.26%

This rate reflects the return required by preferred shareholders after considering flotation costs.

Advantages and Disadvantages of Preferred Stock

• Advantages: Preferred stock offers a fixed dividend, providing dividend stability. It does not typically carry voting rights, thus not diluting control, and often has priority over common equity in dividends and in bankruptcy.
• Disadvantages: Preferred dividends are not tax-deductible, unlike interest on debt, which can increase the company's effective cost. Moreover, issuing preferred stock can be expensive and dilutive if it converts to common stock in some cases.

Cost of New Common Equity

The cost of new equity (Ke) can be estimated using the dividend growth model (DGM):

Ke = (D1 / Pnet) + g

Where D1 = last dividend × (1 + g) = $3.80 × 1.07 = $4.07; g = 7%; Pnet = $50 - $9 = $41.

Calculating:

Ke = ($4.07 / $41) + 0.07 ≈ 0.099 + 0.07 = 16.9%

This represents the return required by investors for new equity issues, accounting for flotation costs.

Advantages and Disadvantages of Issuing New Equity

• Advantages: Equity does not require fixed payments like debt, reducing financial risk. It also improves the firm's equity base and can support growth.
• Disadvantages: Dilution of ownership, possibly higher cost of capital compared to debt, and issuance costs can be significant, impacting overall profitability.

Cost of New Debt

The cost of debt (Kd) considers the coupon rate, flotation costs, and tax shield:

Kd = [(Coupon payment / Net proceeds) ] × (1 - Tax rate)

Coupon payment = 6% of $1000 = $60.

Proceeds after flotation costs = $1000 - (7% of $1000) = $930.

Hence, pre-tax cost:

Kd = $60 / $930 ≈ 6.45%

Applying tax shield:

After-tax cost of debt = 6.45% × (1 - 0.40) = 3.87%

This rate indicates the effective after-tax cost of new debt for the firm.

Advantages and Disadvantages of Issuing New Debt

• Advantages: Debt interest is tax-deductible, reducing overall tax burden; it typically has lower costs compared to equity; and maintains control without dilution.
• Disadvantages: Increased leverage raises financial risk, potentially leading to financial distress if not managed properly; covenants and repayment obligations can constrain flexibility.

Calculating the Weighted Average Cost of Capital (WACC)

Using the component costs and the company's capital structure weights:

• Preferred stock weight = 10% (0.10)
• Debt weight = 30% (0.30)
• Equity weight = 60% (0.60)

The WACC formula:

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

Insert the component costs:

WACC = 0.60 × 16.9% + 0.30 × 3.87% + 0.10 × 5.26% ≈ 10.14% + 1.16% + 0.53% ≈ 11.83%

This WACC reflects the average rate required for the company's capital investments, integrating the costs and proportions of all sources of capital.

Advantages and Disadvantages of Using WACC in Capital Budgeting

• Advantages: Provides a single hurdle rate incorporating risk and capital structure; facilitates objective project evaluation; enhances consistency across investment decisions.
• Disadvantages: Assumes stable capital structure and market conditions; may oversimplify project-specific risks; may not be suitable for projects with different risk profiles than the firm’s average.

Conclusion and Recommendations

Based on the calculations and considerations, Coogly’s WACC of approximately 11.83% serves as a comprehensive benchmark for evaluating investment opportunities. Its effective integration of various capital components and their associated costs underscores its utility in capital budgeting and strategic planning. However, firms must be cautious of the assumptions inherent in WACC calculations and periodically review the cost components to adjust for market fluctuations and changing risk profiles. Ultimately, when applied judiciously, WACC is a valuable tool for guiding informed, value-enhancing investment decisions.

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