Question

Turnbull Co. has a target capital structure of 58% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, 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 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:

0.75%

Explanation:

In the first place, the weighted average cost of capital is the average cost of finance a firm incurs on aggregate on all its sources of finance a shown by the formula below:

WACC=(weight of equity*cost of equity)+(weight of preferred stock*cost of preferred stock)+(weight of debt*before-tax cost of debt )*(1-tax rate)

Note only debt has tax impact deduction

tax rate=40%

WACC using retained earnings:

WACC=(36%*14.7%)+( 6%* 12.2%)+(58%* 11.1%)*(1-40%)

WACC=9.89%

WACC using new common equity:

cost of new common equity=16.8%

WACC=(36%*16.8%)+( 6%* 12.2%)+(58%* 11.1%)*(1-40%)

WACC=10.64%

increase in WACC=10.64%-9.89%

increase in WACC=0.75%