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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 8 months ago
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