Question

In: Finance

The firm's target capital structure is the mix of debt, preferred stock, and common equity the...

The firm's target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise funds for its future projects. The target proportions of debt, preferred stock, and common equity, along with the cost of these components, are used to calculate the firm's weighted average cost of capital (WACC). If the firm will not have to issue new common stock, then the cost of retained earnings is used in the firm's WACC calculation. However, if the firm will have to issue new common stock, the cost of new common stock should be used in the firm's WACC calculation.

Quantitative Problem: Barton Industries expects that its target capital structure for raising funds in the future for its capital budget will consist of 40% debt, 5% preferred stock, and 55% common equity. Note that the firm's marginal tax rate is 25%. Assume that the firm's cost of debt, rd, is 9.7%, the firm's cost of preferred stock, rp, is 8.9% and the firm's cost of equity is 12.3% for old equity, rs, and 12.7% for new equity, re.

What is the firm's weighted average cost of capital (WACC1) if it uses retained earnings as its source of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

  

What is the firm’s weighted average cost of capital (WACC2) if it has to issue new common stock? Do not round intermediate calculations. Round your answer to two decimal places.

  

Solutions

Expert Solution

Calculating WACC1 = WACC if retained earnings are used as source of common equity

Weight of debt = 40% , Weight of preferred stock = 5% and Weight of common equity = Weight of retained earnings = 55%

Cost of debt = 9.7%, Cost of preferred stock = 8.9% , Cost of common equity = Cost of retained earnings = 12.3%

WACC1 = Weight of debt x Cost of debt x (1 - tax rate) + Weight of preferred stock x cost of preferred stock + Weight of retained earnings x Cost of retained earnings

WACC1 = 40% x 9.7% x (1 - 25%) + 5% x 8.9% + 55% x 12.3%

WACC1 = 2.91% + 0.4450% + 6.7650% = 10.12%

Hence, if retained are used as source of common equity then WACC = WACC1 = 10.12%

Calculating WACC if firm issued new common stock

Weight of debt = 40% , Weight of preferred stock = 5% and Weight of common equity = Weight of new common stock = 55%

Cost of debt = 9.7%, Cost of preferred stock = 8.9% , Cost of common equity = Cost of new common stock = 12.7%

WACC = Weight of debt x Cost of debt x (1 - tax rate) + Weight of preferred stock x cost of preferred stock + Weight of new common stock x Cost of new common stock

WACC = 40% x 9.7% x (1 - 25%) + 5% x 8.9% + 55% x 12.7%

WACC = 2.91% + 0.4450% + 6.9850% = 10.34%

Hence, WACC if company issued new common stock = WACC2 = 10.34%

jeff jeffy answered 9 months ago
Next > < Previous

Related Solutions

The firm's target capital structure is the mix of debt, preferred stock, and common equity the...
The firm's target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise funds for its future projects. The target proportions of debt, preferred stock, and common equity, along with the cost of these components, are used to calculate the firm's weighted average cost of capital (WACC). If the firm will not have to issue new common stock, then the cost of retained earnings is used in the firm's WACC calculation. However, if...
Pearson motors has a target capital structure of 30% debt and 70% common equity, with no preferred stock.
Pearson motors has a target capital structure of 30% debt and 70% common equity, with no preferred stock. The yield to maturity on the company’s out standing bonds is 9%, and its tax rate is 40%. Pearsons CFO estimates that the company’s WACC is 10.50%. What is Pearson’s cost of common equity?
The firm’s target capital structure is 60% common stock, 30% debt, and 10% preferred stock. Debt:...
The firm’s target capital structure is 60% common stock, 30% debt, and 10% preferred stock. Debt: 7,000 5.0% coupon bonds outstanding, with 11 years to maturity, $1,000 par value and a quoted price of 106.25% of par value. These bonds pay interest semiannually. Common Stock: 300,000 shares of common stock selling for $65.40 per share. The stock has a beta of 1.44. Preferred Stock: 8,500 shares of preferred stock selling at $96.00 per share and pay annual dividends of $5.70....
7. Prego Corp. has a target capital structure of 30% debt, 60% common equity, and preferred...
7. Prego Corp. has a target capital structure of 30% debt, 60% common equity, and preferred stock of 10%. The yield to maturity on the company’s outstanding bonds is 9%, and its tax rate is 21%. The cost of preferred stock is 5%. Prego’s CFO estimates that the company’s WACC is 9.96%. What is Prego’s cost of equity? 8. If the total capital structure is $90,000,000 and the debt to equity ratio is 50%, what is the dollar amount of...
Your company has a target capital structure of 40% debt, 15% preferred, and 45% common equity....
Your company has a target capital structure of 40% debt, 15% preferred, and 45% common equity. Your bonds carry a 9% coupon, have a par value of $1,000, and 7 years remaining until maturity. They are currently selling for $950.51. The cost of preferred is 7.50%. The risk free rate is 4%, the market risk premium is 8%, and beta is 1.0. The firm will not be issuing any new stock, and the tax rate is 40%. What is its...
Crown Hill Berhad has a target capital structure consisting of debt (bond), preferred stock, and common...
Crown Hill Berhad has a target capital structure consisting of debt (bond), preferred stock, and common stock. The capital structure for Crown Hill Berhad is as follows:              Source of Capital                  Market Value              Debt (bond)                            RM500,000              Preferred Stock                      RM300,000              Common Stock                      RM700,000 Debt Crown Hill Berhad’s bond have a 12 percent coupon rate paid annually, with maturity period of 15 years and sells for RM1,050. The company’s marginal tax rate is 34 percent. Preferred Stock The preferred...
Crown Hill Berhad has a target capital structure consisting of debt (bond), preferred stock, and common...
Crown Hill Berhad has a target capital structure consisting of debt (bond), preferred stock, and common stock. The capital structure for Crown Hill Berhad is as follows:              Source of Capital                  Market Value              Debt (bond)                            RM500,000              Preferred Stock                      RM300,000              Common Stock                       RM700,000 Debt Crown Hill Berhad’s bond have a 12 percent coupon rate paid annually, with maturity period of 15 years and sells for RM1,050. The company’s marginal tax rate is 34 percent. Preferred Stock The preferred...
Yamin Co has a target capital structure of 45% debt, 4% preferred stock and 51% common...
Yamin Co has a target capital structure of 45% debt, 4% preferred stock and 51% common equity. It has before tax cost of debt 11.1% and its cost of preferred stock is 12.2%. if Yasmin can raise all of its equity from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. a. If it current tax rate is 40% how much higher...
Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common...
Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. If its current tax rate is 25%, how much...
Bartlett Company's target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax...
Bartlett Company's target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using reinvested earnings is 12.75%. The firm will not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is its WACC?
ADVERTISEMENT
Subjects
ADVERTISEMENT
Latest Questions
ADVERTISEMENT