Question

Compustat Corporation needs $200 million of total financing for the next 5 years. Their capital structure is currently $10million of preferred stock, $25million of debt, and $45million of common stock. They want to maintain this target capital structure. They have $25million of retained earnings at a cost of 15%.  New equity will cost17 %. They can raise $15 million of 6% debt and another $30 million of 7½% debt. The cost of preferred stock is fixed at 12%. TAX RATE = .40

a. What is the WACC at the first dollar of financing (show your work)?

b.. At what level of total financing will the first breakpoint occur and what source of financing will run out at this point (show your work)?

c. What will be the WACC at the last dollar raised

Answer 1

WACC = After tax cost of debt*weight of debt + cost of preferred stock*weight of preferred stock + cost of equity*weight of equity

First dollar of capital will be raised proportionately through retained earnings, cheaper debt and preferred stock

Hence, WACC = 6%*(1-40%)*25/80 + 12%*10/80 + 15%*45/80

= 11.0625%

b.Retained earnings will run out at 25 million/56.25% = $44.44 million

Cheaper debt at 15 million/31.25% = $48 million

Hence, Retained earnings will run out at $44.44 million

c. WACC of last dollar = 7.5%*(1-40%)*25/80 + 12%*10/80 + 17%*45/80

= 12.46875%

i.e. 12.47%