In: Finance

The Cost of Capital

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 40%.

Assume that the firm's cost of debt, ld, is 6.8%, the firm's cost of preferred stock, Tp, is 6.3% and the firm's cost of equity is 10.8% for old equity, rs, and 11.25% for new equity, re.

a)What is the firm's weighted average cost of capital (WACC) if it uses retained earnings as its source of common equity? Round your answer to 3 decimal places. Do not round intermediate calculations.

b)What is the firm's weighted average cost of capital (WACC) if it has to issue new common stock? Round your answer to 3 decimal places. Do not round intermediate calculations.

Solutions

Expert Solution

weighted average cost of capital (WACC) if it uses retained earnings as its source of common equity

cost of debt, ld, is 6.8%

cost of preferred stock, Tp, is 6.3%

cost of equity is 10.8%

WACC1 = wd x rd x (1 - tax) + wp x rp + we x re

= 40% x 6.8% x (1 - 40%) + 5% x 6.3% + 55% x 10.8%

= 7.887%

weighted average cost of capital (WACC) if it has to issue new common stock

cost of debt, ld, is 6.8%

cost of preferred stock, Tp, is 6.3%

cost of equity is 11.25%

WACC2 = 40% x 6.8% x (1 - 40%) + 5% x 6.3% + 55% x 11.25%

= 8.1345%

WACC1-7.887% ,WACC2 -8.1345%