GSB 615 WACC Project
The exhibits at the end of this case contain balance sheets and income statements for a
small Midwestern manufacturing firm. The data include actual financial statements for
2004 – 2008 and pro forma statements for 2009. You are to use that data to solve the
following case:
You are a treasury analyst for a small Midwestern manufacturing firm. The firm has just
released its 2008 financial statements, and you recently produced a preliminary set of pro
forma statements for 2009 as well. Your pro forma statements indicate that the firm will
need to raise $2.6 million in additional funds to support the business plan for 2009
reflected in the pro forma financial statements (see the AFN figure at the bottom of the
2009 pro forma balance sheet). It is your belief (although it has never been expressly
stated by anyone in the firm) that the CFO has established a target capital structure, and
that new funds are to be raised in such a way as to maintain that target capital structure.
You also believe (although it too has never been verified) that the firm has a specified
dividend payout ratio.
At a recent meeting, the new CEO asked your boss what the firm’s cost of capital is, and
your boss was only able to give an estimate. The CEO was displeased with his response,
and demanded an accurate calculation of the firm’s weighted average cost of capital
(WACC), both when using retained earnings and when issuing new common equity. He
further demanded to know if the expected retained earnings from the 2008 pro forma
statements would be enough to cover the equity portion of the AFN for 2008, or if the
firm would need to issue new equity. Flustered, your boss (who has not bothered to look
at your pro forma statements) told the CEO that it was your responsibility to analyze the
pro forma statements and calculate the WACC, and that you would follow up with the
CEO right away. Your boss informed you of this as he was grabbing his golf clubs and
heading to the airport for a long weekend in Florida.
You need to calculate the following items:
1. The firm’s implied tax rate 2004 – 2008;
2. The firm’s dividend payout ratio and its complement, the retention ratio, 2004 –
2008;
3. The firm’s Return on Equity (ROE) for 2008 only;
4. The firm’s expected growth rate (g), calculated as ROE multiplied by the
retention ratio, for 2008 only;
5. The net price for floating new preferred stock (using 2008 data);
6. The net price for floating new common stock (using 2008 data);
7. The component costs of capital for debt (before and after taxes), new preferred
equity, retained earnings, and new common equity (based on 2008 data);
8. The weights of debt, preferred equity and common equity 2004 – 2008 (use the
book value of debt for the weight of debt, and the market values of preferred &
common equity for their weights, and make sure all the weights add up to 1);
9. The WACC under 2 scenarios, using retained earnings and using new common
equity, both calculated using the Gordon (DCF) model (make sure the weights
add up to 1);
10. The amounts of new debt, preferred equity and common equity needed to be
raised to meet the 2009 AFN requirements and maintain the target capital
structure implied in the data.
Make the following assumptions in your analysis:
1. The 2009 pro forma market share price is equal to the 2008 actual end of
year share price of $7.75;
2. New debt can be raised at an interest rate of 8.5% for both short-term and
long-term debt;
3. Flotation costs for both new preferred equity and new common equity are
equal to 6% of the share price (use the 2008 actual price as the expected
2009 share price for both common and preferred);
4. New debt, new preferred shares and new common shares can be issued in
any amount necessary at the costs calculated;
5. The average tax rate for 2004-2008 is to be used to calculate the after-tax
cost of debt.
Answer the following questions:
1. Does the firm appear to have a targeted payout ratio? If so, what is it?
2. Does the firm appear to have a targeted capital structure? If so, what is it?
3. Will the firm have enough retained earnings to cover the funds needed for 2009?
If not, how much new equity will they have to issue?
4. Given the answer to #3 above, what is the firm’s expected WACC for 2009?
This assignment is due on the due date of the final exam. On that date you must turn in a
two-page paper. The first page will have the answers to the 4 questions listed above. The
second page will have the Excel calculations for the 10 items also listed above. Finally,
you will email an Excel file containing the 10 calculations to my email account no later
than 12:00 PM (noon) on the due date. Late assignments will not be accepted.
