Question

A firm is planning to change its capital structure. Its current capital structure consists of 70% common equity, 20% debt, and 10% preferred stock. The pre-tax cost of debt is 4%, cost of preferred stock is 6% and cost of common equity is 11%. What is the change in its WACC (indicate an increase or a decrease in WACC) if this firms plan to adopt a new capital structure with 60% common equity, 25% debt, and 15% preferred stock if the costs for these components are 3% after-tax cost of debt, 6.5% cost of preferred stock, and 13% cost of common equity? The firm's tax rate stays at 40%.

Answer 1

The old WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke+wps*kps

where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Wps= percentage of preference shares in the capital structure

Kps= cost of preference shares

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC = 0.20*4%*(1 - 0.40) + 0.10*6% + 0.70*11%

= 0.20*2.4% + 0.10*6% + 0.70*11%

= 0.48% + 0.60% + 7.70%

= 8.78%

The new WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke+wps*kps

where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Wps= percentage of preference shares in the capital structure

Kps= cost of preference shares

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC = 0.25*3% + 0.15*6.5% + 0.60*13%

  = 0.75% + 0.9750% + 7.80%

= 9.5250%

Change in WACC = 9.5250% - 8.78%

= 0.7450% 0.75%.