Chapter 11, Problem 15P

WACC Estimation

On January 1, the total market value of the Tysseland Company was $60 million. During the year, the company plans to raise and invest $30 million in new projects. The firm’s present market value capital structure, shown here, is considered to be optimal. There is no short-term debt.

New bonds will have an 8% coupon rate, and they will be sold at par. Common stock is currently selling at $30 a share. The stockholders’ required rate of return is estimated to be 12%, consisting of a dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is $1.20, so the dividend yield is $1.20/$30 = 4%.) The marginal tax rate is 40%.

1. a. In order to maintain the present capital structure, how much of the new investment must be financed by common equity?
2. b. Assuming there is sufficient cash flow for Tysseland to maintain its target capital structure without issuing additional shares of equity, what is its WACC?
3. c. Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC? No numbers are required to answer this question.