Question

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 25%. Assume that the firm's cost of debt, rd, is 10.7%, the firm's cost of preferred stock, rp, is 9.9% and the firm's cost of equity is 13.3% for old equity, rs, and 13.9% 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?

Answer 1

WACC = 11.02%

Step-by-step explanation:

Since it is going to use "retained earnings" to source common equity, we take cost of equity to be 13.3% NOT 13.9% for new equity, because they are going to use retained earnings.

The Weighted Average Cost of Capital (WACC) formula is:

`WACC=W_eKe+WpKp+WdKd(1-T)`

The W's are the respective weights of equity, preferred stock, and debt in the portfolio

The K's are the cost of each respectively

T is the tax rate

We are given the information, we simply plug them into the formula and find the WACC. Shown below:

`WACC=W_eKe+WpKp+WdKd(1-T)\\WACC=(0.55)(0.133)+(0.05)(0.099)+(0.4)(0.107)(1-0.25)\\WACC=0.1102`

Converting to percentage,

WACC = 0.1102 * 100 = 11.02%