Question

Mullineaux Corporation has a target capital structure of 60 percent common stock, 5 percent preferred stock, and 35 percent debt. Its cost of equity is 12 percent, the cost of preferred stock is 5 percent, and the pretax cost of debt is 7 percent. The relevant tax rate is 35 percent.
a. What is Mullineaux's WACC?
b. The companies president has approached you about Mullineaux's capital structure. He wants to know why the company doesn't use more preferred stock financing because it costs less than debt. What would you tell the president?

Answer 1

Answer:

a. Mullineaux's WACC = 0.60*12 + 0.05*5 + 0.35*7*(1 - 0.35)

WACC = 7.2 + 0.25 + 0.35*7*0.65

WACC = 7.2 + 0.25 + 1.5925

WACC = 9.0425%

WACC = 9.04%

b. After tax cost of debt = 7*(1 - 0.35)

After tax cost of debt = 7*0.65

After tax cost of debt = 4.55%

So since after tax cost of debt of 4.55% is less than the preferred cost of 5%, company should use debt in its capital structure.