A corporation has the following balance sheet (liabilities side):
Current liabilities $2,000 Rr 8%
Long term debt $5,000 Tax rate 50%
Preferred stock $2,000 Stock price $20
Common stock $8,000 Dividends $1
Retained earnings $3,000
The current riskless rate is 8%; the corporate tax rate is 50%; the current price of a share of common stock is $20 and dividends have been level at $1 per share per year for many years.
Recently company executives have considered expanding the existing business by acquiring a competitor. To do so, they must calculate the WACC of the firm and estimate the NPV of the acquisition. Because the acquisition is of the same risk as the firm, the WACC (unlevered equity cost) can be used.
A financial executive has used the following procedure to calculate the WACC. Debt and preferred stock are fixed claims offering a fairly secure constant return, and so their before tax cost is assumed to equal the riskless rate. The dividend yield has held constant at about 5%; so this is used as the cost of new and retained equity. Finally, the balance sheet shows the firm to be composed of 25% debt, 10% preferred, 55% equity (common plus retained), and 10% current liabilities. Current liabilities are assumed to be costless; therefore the WACC is 4.55%. Comment on this procedure.
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