Question

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, rd, is 6.9%, the firm's cost of preferred stock, rp, is 6.4% and the firm's cost of equity is 10.9% for old equity, rs, and 11.51% for new equity, re. 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. 68.97 % 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

a. With New Stock = 8.307%

b. With Old stock = 7.971%

Step-by-step explanation:

The weighted average cost of capital (WACC) defines the cost rate that blends the capital structure cost including equity, debt, and preferred stock.

Requirement A

If it uses retained earnings as its source of common equity,

Given,

The weight of the combination of the capital structure is -

`W_(d)` = 40% = 0.40;
`W_(p)` = 5% = 0.05;
`W_(e)` = 55% = 0.55

For cost of debt, we have to find cost of debt after tax,
`R_(d)(1 - t)` =

6.9% x (1 - 0.40) = 4.14%

Cost of preferred stock,
`R_(p)` = 6.4%

Cost of new Equity,
`R_(e)` = 11.51%

We know, the weighted average cost of capital (WACC) =

`W_(d)` x
`R_(d)` +
`W_(p)` x
`R_(p)` +
`W_(e)` x
`R_(e)`

= (0.40 x 4.14%) + (0.05 x 6.4%) + (0.55 x 11.51%)

= 1.656% + 0.32% + 6.3305%

= 8.307%

Requirement B

If it has to issue new common stock, the weighted average cost of capital (WACC) =
`W_(d)` x
`R_(d)` +
`W_(p)` x
`R_(p)` +
`W_(s)` x
`R_(s)`

Given,

The weight of the combination of the capital structure is -

`W_(d)` = 40% = 0.40;
`W_(p)` = 5% = 0.05;
`W_(e)` = 55% = 0.55

For cost of debt, we have to find cost of debt after tax,
`R_(d)(1 - t)` =

6.9% x (1 - 0.40) = 4.14%

Cost of preferred stock,
`R_(p)` = 6.4%

Cost of new Equity,
`R_(s)` = 10.9%

Therefore, putting the value in the equation,

WACC = (0.40 x 4.14%) + (0.05 x 6.4%) + (0.55 x 10.9%)

WACC = 1.656% + 0.32% + 5.995%

WACC = 7.971%