WACC Calculation & Capital Budgeting Decisions

Posted on May 26, 2025 in Finance

Weighted Average Cost of Capital (WACC) Applications

This document presents two case studies demonstrating the calculation of the Weighted Average Cost of Capital (WACC) and its application in capital budgeting decisions. Each case includes a problem statement, detailed calculations, and project acceptance criteria.

Case Study 1: Empire Electric Company (EEC)

Problem Statement: EEC WACC & Project Selection

Empire Electric Company (EEC) utilizes only debt and common equity in its capital structure. The company can borrow unlimited amounts at an interest rate (R_d) of 9% as long as it maintains its target capital structure, which consists of 35% debt and 65% common equity. EEC’s last dividend (D₀) was $2.20, and its common stock currently sells for $26. The expected constant dividend growth rate (g) is 6%. EEC’s tax rate is 40%.

Two projects are under consideration, both equally risky and similar in risk to the firm’s existing assets:

• Project A: Rate of return = 12%
• Project B: Rate of return = 11%

Questions:

1. What is EEC’s cost of common equity?
2. What is EEC’s Weighted Average Cost of Capital (WACC)?
3. Which projects should Empire Electric Company accept?

Solution:

Given Data for EEC:

• Debt Interest Rate (R_d): 9%
• Target Debt Weight (w_d): 35%
• Target Common Equity Weight (w_e): 65%
• Last Dividend (D₀): $2.20
• Expected Constant Growth Rate (g): 6%
• Current Stock Price (P₀): $26
• Tax Rate (T): 40%

Calculations:

1. Cost of Debt (After-Tax):

   R_d(1 – T) = 9% (1 – 0.40) = 9% (0.60) = 5.4%

2. Cost of Common Equity (R_s):

   Using the Dividend Growth Model (Gordon Growth Model):

   R_s = [D₀(1 + g) / P₀] + g

   R_s = [$2.20(1.06) / $26] + 0.06

   R_s = [$2.332 / $26] + 0.06

   R_s = 0.08969 + 0.06 = 0.14969 ≈ 14.97%

3. Weighted Average Cost of Capital (WACC):

   WACC = (w_d * R_d(1 – T)) + (w_e * R_s)

   WACC = (0.35 * 5.4%) + (0.65 * 14.97%)

   WACC = 1.89% + 9.7305% = 11.6205% ≈ 11.62%

Project Acceptance Decision:

The firm’s WACC is 11.62%. Since both projects are equally risky and as risky as the firm’s other assets, EEC should accept projects with a rate of return greater than its WACC.

• Project A: Rate of return = 12%. Since 12% > 11.62%, Project A should be accepted.
• Project B: Rate of return = 11%. Since 11% < 11.62%, Project B should not be accepted.

Case Study 2: Adamson Corporation

Problem Statement: Adamson WACC & Optimal Capital Budget

Adamson Corporation is evaluating four average-risk projects with the following costs and expected rates of return:

The company estimates it can issue debt at a rate (R_d) of 10%, and its tax rate is 30%. It can issue preferred stock that pays a constant dividend of $5.00 per year at $50.00 per share. Its common stock currently sells for $38.00 per share; the next expected dividend (D₁) is $4.25, and the dividend is expected to grow at a constant rate (g) of 5% per year.

The target capital structure consists of 75% common stock, 15% debt, and 10% preferred stock.

Questions:

1. What is the cost of each of Adamson Corporation’s capital components?
2. What is Adamson Corporation’s WACC?
3. Based on the criterion that only projects with expected returns exceeding the WACC will be accepted, which projects should Adamson Corporation accept?

Solution:

Given Data for Adamson Corporation:

• Debt Interest Rate (R_d): 10%
• Tax Rate (T): 30%
• Preferred Stock Dividend (D_p): $5.00
• Preferred Stock Price (P_p): $50.00
• Current Common Stock Price (P₀): $38.00
• Next Expected Dividend (D₁): $4.25
• Common Stock Growth Rate (g): 5%
• Target Capital Structure:
  • Common Stock (w_e): 75%
  • Debt (w_d): 15%
  • Preferred Stock (w_p): 10%

Calculations:

1. Cost of Each Capital Component:

   • After-Tax Cost of Debt (R_d(1 – T)):

     0.10 (1 – 0.30) = 0.10 (0.70) = 7.00%

   • Cost of Preferred Stock (R_p):

     R_p = D_p / P_p = $5.00 / $50.00 = 0.10 = 10.00%

   • Cost of Common Stock (R_s):

     Using the Dividend Growth Model (Gordon Growth Model):

     R_s = (D₁ / P₀) + g

     R_s = ($4.25 / $38.00) + 0.05

     R_s = 0.11184 + 0.05 = 0.16184 ≈ 16.18%

2. Weighted Average Cost of Capital (WACC):

   WACC = (w_d * R_d(1 – T)) + (w_p * R_p) + (w_e * R_s)

   Component	Weight	After-Tax Cost	Weighted Cost
   Debt	0.15	7.00%	1.05%
   Preferred Stock	0.10	10.00%	1.00%
   Common Stock	0.75	16.18%	12.14%
   Total WACC			14.19%

Project Acceptance Decision:

Adamson Corporation will accept projects only if their expected rates of return exceed the calculated WACC of 14.19%.

• Project 1: Expected return = 16.00%. Since 16.00% > 14.19%, Project 1 should be accepted.
• Project 2: Expected return = 15.00%. Since 15.00% > 14.19%, Project 2 should be accepted.
• Project 3: Expected return = 13.75%. Since 13.75% < 14.19%, Project 3 should not be accepted.
• Project 4: Expected return = 12.50%. Since 12.50% < 14.19%, Project 4 should not be accepted.

Therefore, Adamson Corporation should accept Project 1 and Project 2.

Additional Note:

The original document included a note with the calculation: 0.15 x 0.10 (1.03) + 0.75 x 0.05 = 0.0105. This calculation does not directly correspond to the WACC components or the final WACC value derived for Adamson Corporation in this solution. It appears to be an unrelated or partial calculation.