Question

Turnbull co. has a target capital structure of 58% debt, 6% preferred stock, and 36% 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.) 0.68% 0.99% 0.91% 0.76%

Answer 1

The weighted average cost of capital (WACC) is the average rate of return a company needs to earn on its investments to satisfy its investors. Turnbull Co.'s WACC can be calculated based on its target capital structure and the costs of its components. The difference in WACC between raising additional common equity through retained earnings and issuing new stock is 0.91%.

Step-by-step explanation:

The weighted average cost of capital (WACC) is the average rate of return a company needs to earn on its investments in order to satisfy its investors. To calculate Turnbull Co.'s WACC, we need to consider the cost of each component of its capital structure.

The WACC formula is: WACC = (Wd × Rd × (1 - Tax Rate)) + (Wps × Rps) + (We × Re)

• Where Wd, Wps, and We are the weights of debt, preferred stock, and common equity respectively, and Rd, Rps, and Re are the costs of debt, preferred stock, and common equity respectively.
• Since Turnbull Co.'s tax rate is 25% and its target capital structure consists of 58% debt, 6% preferred stock, and 36% common equity, we can now calculate its WACC.
• If Turnbull Co. can raise all its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it needs to raise new common equity, its cost will be 16.8%.
• Plugging in the values, the WACC without issuing new common stock is 10.2%.
• For the scenario where additional common equity is raised by issuing new stock, we need to calculate a new value for We.
• This can be done using the formula: We = (D/V) × Re + (E/V) × Re
• Where D/V and E/V are the proportions of debt and equity in the company's current capital structure.
• Substituting the values, we get We = (0.58 × 0.111) + (0.36 × 0.168) = 0.06438 + 0.06048 = 0.12486 or 12.49%
• Using this new value for We, we can now calculate the WACC for the scenario where new common equity is issued. Plugging in the values, the WACC is 11.11%.
• The difference between the two WACCs is 11.11% - 10.20% = 0.91%, rounded to two decimal places.