Question

Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equality. 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 euity 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 40%, how much higher will Turnbull’s weighed 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?
a) 0.75%

b) 0.90%

c) 0.68%

d) 0.98%

Answer 1

Answer:

Raising the Funds through Retained Earnings

WACC = Ke(E/V) + Kp(P/V) + Kd(D/v)(1-T)

WACC = 14.7(0.36) + 12.2(0.06) + 11.1(0.58)(1-0.40)

WACC = 5.292 + 0.732 + 3.8628

WACC = 9.89%

Raising New Equity

WACC = Ke(E/V) + Kp(P/V) + Kd(D/v)(1-T)

WACC = 16.8(0.36) + 12.2(0.06) + 11.1(0.58)(1-0.40)

WACC = 6.048 + 0.732 + 3.8628

WACC = 10.64%

Difference in WACC = 10.64% - 9.89%

                                  = 0.75%

Explanation:

WACC equals cost of equity multiplied by proportion of equity in the capital structure plus cost of preferred stock multiplied by proportion of preferred stock in the capital structure plus after-tax cost of debt multiplied by proportion of debt in the capital structure.

In this case, there is need to calculate WACC if funds were raised through retained earnings and WACC if funds were raised through new common stock. Then, we will determine the difference in WACC.