Question

Turnbull Co. has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%.

If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%.

If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? (Note: Round your intermediate calculations to two decimal places.)

1.28%

1.34%

1.39%

1.07%

Answer 1

Weight of Debt = Wd =45%

Weight of Preferred stock =Wp = 4%

Weight of Common equity = We =51%

Before tax cost of debt = rd = 11.1%

Cost of Preferred stock = rp = 12.2%

Cost of retained earnings = rs = 14.7%

Cost of new Equity = re =16.8%

Tax Rate = t = 25%

WACC if retained earnings are used = [(Wd*rd*(1-t)) + (Wp*rp) + (We*rs)]

= [(45% * 11.1%*(1-25%)) + (4%*12.2%) + (51%*14.7%)]

= 3.74625% + 0.488% + 7.497%

= 11.73125%

WACC if new common stock is issued = [(Wd*rd*(1-t)) + (Wp*rp) + (We*re)]

= [(45% * 11.1%*(1-25%)) + (4%*12.2%) + (51%*16.8%)]

= 3.74625% + 0.488% + 8.568%

= 12.80225%

Additional WACC if new common stock is issued instead of retained earnings = WACC if new common stock is issued - WACC if retained earnings are used

= 12.80225% - 11.73125%

= 1.071%

Therefore, Additional WACC if new common stock is issued instead of retained earnings is 1.07%