Question

The Cost of Capital: Weighted Average Cost of Capital

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 40%. Assume that the firm's cost of debt, r_d, is 7.1%, the firm's cost of preferred stock, r_p, is 6.6% and the firm's cost of equity is 11.1% for old equity, r_s, and 11.6% for new equity, r_e. What is the firm's weighted average cost of capital (WACC₁) if it uses retained earnings as its source of common equity? Round your answer to 3 decimal places. Do not round Intermediate calculations.
%

What is the firm’s weighted average cost of capital (WACC₂) if it has to issue new common stock? Round your answer to 3 decimal places. Do not round Intermediate calculations.
%

Answer 1

First of all lets find after tax cost of debt

After tax cost of debt = cost of debt(1-tax rate)

= 7.1%(1-40%)

= 7.1%(1-0.4)

= 7.1%(0.6)

= 4.26%

Statement showing WACC if  it uses retained earnings as its source of common equity

Particulars	Weight	Cost of capital	WACC
a	b	c =axb
Equity	55%	11.100%	6.105%
Pref shares	5%	6.600%	0.330%
Debt	40%	4.260%	1.704%
WACC			8.139%

Thus WACC1 = 8.139%

Statement showing WACC if  it uses new equity as its source of common equity

Particulars	Weight	Cost of capital	WACC
a	b	c =axb
Equity	55%	11.600%	6.380%
Pref shares	5%	6.600%	0.330%
Debt	40%	4.260%	1.704%
WACC			8.414%

Thus WACC2 = 8.414%