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