Question

Turnbull Company has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.10%, and its cost of preferred stock is 12.20%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.70%. However, if it is necessary to raise new common equity, it will carry a cost of 16.80%.
If its current tax rate is 40%, 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 retianed earnings?

Answer 1

Answer:

Difference in WACC =0.72%

Explanation:

As per the data given in the question,

Calculation for the Weighted Average Cost of Capital (WACC):

WACC = Common equity × Equity cost + preferred stock × cost of preferred stock + (Debt × (cost of debt ( 1 - tax rate)))

= (36% × 14.7%) + (6% × 12.2%) + (58% × (11.10% ( 1 - 40%)))

= 0.098868

= 9.89%

If it is necessary to carry a new equity then,

WACC = (36% × 16.8%) + (6% × 12.2%) + (58% × (11.10% ( 1 - 40%)))

= 0.10608

= 10.61%

Difference = 10.61% - 9.89%

=0.72%