Coogly Company Weighted Average Cost Of Capital Analysis
Coogly Company Weighted Average Cost Of Capital Analysis 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.
What is the component cost for Coogly's preferred stock? What are the advantages and disadvantages of using preferred stock in the capital structure?
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, expected to grow at 7%. What is the cost of new equity to the firm?
What are the advantages and disadvantages of issuing new equity in the capital structure?
The company will use new bonds for capital projects, with a market and par value of $1000, coupon rate of 6%, floatation cost of 7%, and maturity in 20 years. No other debt will be used for negotiations. What is the cost of new debt?
What are the advantages and disadvantages of issuing new debt?
Given these component costs and structure, what is the weighted average cost of capital for Coogly? What are the advantages and disadvantages of using this method in capital budgeting?
Please include an informative chart or graph, organize your presentation clearly, and use the notes section to clarify key points.
Paper For Above instruction
Introduction
The weighted average cost of capital (WACC) is a fundamental metric used in corporate finance to evaluate the average rate of return required by a company's investors across all sources of capital. It serves as a critical tool in capital budgeting, investment analysis, and financial decision-making. For Coogly Company, accurately calculating the WACC entails determining the component costs of preferred stock, equity, and debt, followed by applying their respective weights within the capital structure. This paper explores each component's cost, discusses the advantages and disadvantages associated with each financing source, and ultimately provides a comprehensive WACC calculation. Additionally, it discusses the strategic implications of employing WACC as a valuation tool.
Component Cost of Preferred Stock
Preferred stock typically offers fixed dividends and a priority claim over common equity but ranks after debt obligations. The component cost for preferred stock is calculated as the dividend per share divided by the net issuing price, which accounts for floatation costs.
\[
\text{Cost of Preferred Stock (}K_{ps}\text{)} = \frac{D_{ps}}{P_{net\,ps}}
\]
Where:
\(D_{ps} = \$4\) (dividend per preferred share)
\(P_{gross\,ps} = \$82\) (market price)
Floatation cost per share = \$6
Net proceeds per share:
\[
P_{net\,ps} = P_{gross\,ps} - \text{floatation cost} = 82 - 6 = \$76
\]
Thus,
\[
K_{ps} = \frac{4}{76} \approx 5.26\%
\]
Advantages of Preferred Stock:
- Provides fixed dividends, which can be attractive for investors.
- No voting rights, hence less control dilution.
- No mandatory debt repayment obligations, reducing financial risk.
Disadvantages of Preferred Stock:
- Generally carries higher costs compared to debt.
- Dividend payments are not tax-deductible, unlike interest.
- It dilutes earnings for common shareholders if dividends increase.
Cost of New Equity
The cost of issuing new common equity considers dividend growth, current stock price, and floatation costs. Using the Gordon Growth Model:
\[
K_e = \frac{D_1}{P_{net\,e}} + g
\]
Where:
\(D_1 = D_0 \times (1 + g) = 3.80 \times 1.07 = 4.07\) (next year's dividend)
Market price \(P_{gross\,e} = \$50\)
Floatation cost = \$9
Net proceeds per share:
\[
P_{net\,e} = 50 - 9 = \$41
\]
Calculating \(K_e\):
\[
K_e = \frac{4.07}{41} + 0.07 \approx 0.099 + 0.07 = 17.9\%
\]
Advantages of Issuing New Equity:
- No obligation to pay dividends if profits decline.
- Enhances equity base, reducing leverage ratios.
- Potentially improves company creditworthiness.
Disadvantages of Issuing New Equity:
- Dilutes existing shareholders' ownership.
- Generally more costly than debt financing.
- Time-consuming and subject to market conditions.
Cost of New Debt
The cost of debt accounts for market conditions, coupon rates, floatation costs, and tax benefits:
\[
K_{d\,n} = \frac{C}{P_{net\,d}} \times (1 - T)
\]
Where:
Coupon \(C = 6\%\) of \$1000 = \$60 annually
Gross price \(P_{gross\,d} = \$1000\)
Floatation cost = 7% → \$70 per bond
Net proceeds:
\[
P_{net\,d} = 1000 - 70 = \$930
\]
Calculating before-tax cost:
\[
K_{d\,before\,tax} = \frac{60}{930} \approx 6.45\%
\]
Adjusted for taxes:
\[
K_{d\,after\,tax} = 6.45\% \times (1 - 0.40) \approx 3.87\%
\]
Advantages of New Debt:
- Deductible interest reduces taxable income, lowering tax burden.
- Generally lower cost compared to equity.
- Does not dilute ownership.
Disadvantages of New Debt:
- Increased leverage raises bankruptcy risk.
- Fixed interest obligations can strain cash flows.
- Potentially restrictive covenants.
Calculating Coogly’s WACC
Applying the weights from the capital structure:
\[
WACC = w_{ps} \times K_{ps} + w_{e} \times K_e + w_{d} \times K_d
\]
Where:
Preferred stock weight \(w_{ps} = 10\%\)
Equity weight \(w_e = 60\%\)
Debt weight \(w_d = 30\%\)
Plugging in the component costs:
\[
WACC = 0.10 \times 5.26\% + 0.60 \times 17.9\% + 0.30 \times 3.87\%
\]
\[
WACC = 0.526\% + 10.74\% + 1.161\%
\]
\[
WACC \approx 12.43\%
\]
This calculation indicates that Coogly’s average cost of capital is approximately 12.43%.
Advantages of Using WACC for Capital Budgeting:
- Incorporates the cost of all sources of capital, offering a comprehensive measure.
- Facilitates comparison of investment projects against a realistic hurdle rate.
- Encourages optimal capital structure management.
Disadvantages:
- Sensitive to the accuracy of component costs and weights.
- Market conditions can change rapidly, impacting WACC.
- Assumes constant capital structure over time, which may not reflect strategic shifts.
Conclusion
The calculation of Coogly’s WACC highlights the importance of understanding each component’s cost and their interplay within the capital structure. Preferred stock offers a relatively low-cost, fixed-dividend option but has associated disadvantages such as higher costs and dilution potential. New equity, although more expensive, provides growth flexibility without increasing leverage, while debt remains the least costly source due to tax advantages but introduces financial risk. Combining these elements, Coogly’s estimated WACC of approximately 12.43% provides a robust benchmark for evaluating investment opportunities. While the WACC approach offers valuable insights, it must be used judiciously, considering market dynamics, company risk profile, and strategic goals.
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