Question

The Tyler Oil Company’s capital structure is as follows:

Debt	65	%
Preferred stock	10
Common equity	25

The aftertax cost of debt is 8 percent; the cost of preferred stock is 11 percent; and the cost of common equity (in the form of retained earnings) is 14 percent.

a-1. Calculate Tyler Oil Company’s weighted average cost of capital. (Round the final answers to 2 decimal places.)

	Weighted Cost
Debt (Kd)	%
Preferred stock (Kp)
Common equity (Ke)
Weighted average cost of capital (Ka)	%

As an alternative to the capital structure shown above for Tyler Oil Company’s, an outside consultant has suggested the following modifications.

    

Debt	55%
Preferred stock	25
Common equity	20

Under this new and more debt-oriented arrangement, the aftertax cost of debt is 10.0 percent, the cost of preferred stock is 13 percent, and the cost of common equity (in the form of retained earnings) is 16.5 percent.

a-2. Calculate Tyler’s weighted average cost of capital. (Round the final answers to 2 decimal places.)

	Weighted Cost
Debt (Kd)	%
Preferred stock (Kp)
Common equity (Ke)
Weighted average cost of capital (Ka)	%

b. Which plan is optimal in terms of minimizing the weighted average cost of capital?

• Plan 1

• Plan 2

Please provide correct answers. thanks

Answer 1

a-1.Plan 1

Weighted cost of debt= 0.65*8%

= 5.20%

Weighted cost of preferred stock= 0.10*11%

= 1.10%.

Weighted cost of common equity= 0.25*14%

= 3.50%.

The weighted average cost of capital is calculated using the below formula:

WACC= Wd*Kd(1-t)+Wps*Kps+We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 5.20% + 1.10% + 3.50%

= 9.80%.

a-2. Plan 2

Weighted cost of debt= 0.55*10%

= 5.50%

Weighted cost of preferred stock= 0.25*13%

= 3.25%.

Weighted cost of common equity= 0.20*16.5%

= 3.30%.

The weighted average cost of capital is calculated using the below formula:

WACC= Wd*Kd(1-t)+Wps*Kps+We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 5.50% + 3.25% + 3.30%.

= 12.05%.

b.Plan 1 is optimal in terms of minimizing the weighted average cost of capital.

In case of any query, kindly comment on the solution.