Question

Turnbull Co. has a target capital structure of 45% debt, 4% preferred stock, and 51% 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?

Answer 1

Answer:

By raising additional funds from issuing additional equity common stock ,WAAC increases by 1.07%

Explanation:

WACC=Ke*E/V+Kp*P/V*Kd*D/V*(1-t)

WACC when additional funds is raised from retained earnings:

Ke is the cost of equity is 14.7%

Kd is the cost of debt is  11.1%

Kp is  the cost of preferred stock 12.2%

E=equity weight of 51% 0.51

P= preferred stock weight 4% 0.04

D=debt weight 45% 0.45

V=debt+equity+preferred stock weights

V=0.51+0.04+0.45=1

t is the tax rate at 25% 0.25

WACC=14.7%*0.51/1+12.2%*0.04+11.1%*0.45*(1-0.25)

          =(14.7%*0.51)/1+(12.2%*0.04)+(11.1%*0.45*0.75)

          =11.73%

WACC when additional funds is raised from common equity capital

Ke is the cost of equity is 16.8%

Kd is the cost of debt is  11.1%

Kp is  the cost of preferred stock 12.2%

E=equity weight of 51% 0.51

P= preferred stock weight 4% 0.04

D=debt weight 45% 0.45

V=debt+equity+preferred stock weights

V=0.51+0.04+0.45=1

t is the tax rate at 25% 0.25

WACC=16.8%*0.51/1+12.2%*0.04+11.1%*0.45*(1-0.25)

          =(16.8%*0.51)/1+(12.2%*0.04)+(11.1%*0.45*0.75)

          =12.80%

By raising additional funds from issuing additional equity common stock ,WAAC increases by 1.07% (12.80%-11.73%)