Answer:
Turnbull’s weighted average cost of capital (WACC) will be higher by 0.64% if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings.
Explanation:
Note: This question is not complete. The complete question is therefore provided before answering the question as follows:
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 8.2%, and its cost of preferred stock is 9.3%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 12.4%. However, if it is necessary to raise new common equity, it will carry a cost of 14.2%. 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 retained earnings? (Note: Round your intermediate calculations to two decimal places.)
The explanation to the answer is now given as follows:
Step 1: Calculation of WACC when all of its equity capital is raised from retained earnings
This can be calculated using WACC formula as follows:
WACCR = (WS * CE) + (WP * CP) + (WD * CD * (1 - T)) ………………… (1)
Where;
WACCR = Weighted average cost of capital when all of its equity capital is raised from retained earnings = ?
WS = Weight of common equity = 36%, or 0.36
WP = Weight of preferred stock = 6%, or 0.06
WD = Weight of debt = 58%, or 0.58
CE = Cost of equity = 12.4%, or 0.124
CP = Cost of preferred stock = 9.3%, 0.093
CD = Before-tax cost of debt = 8.2%, or 0.082
T = Tax rate = 40%, or 0.40
Substituting the values into equation (1), we have:
WACCR = (0.36 * 0.124) + (0.06 * 0.093) + (0.58 * 0.082 * (1 - 0.40))
WACCR = 0.078756, or 7.8756%
Rounding to 2 decimal places, we have:
WACCR = 7.88%
Step 2: Calculation of WACC if it raises new common equity
This can also be calculated using WACC formula as follows:
WACCE = (WS * CE) + (WP * CP) + (WD * CD * (1 - T)) ………………… (2)
Where;
WACCE = Weighted average cost of capital if it raises new common equity = ?
WS = Weight of common equity = 36%, or 0.36
WP = Weight of preferred stock = 6%, or 0.06
WD = Weight of debt = 58%, or 0.58
CE = Cost of equity = 14.2%, or 0.142 (Note: This is the only thing that has changed compared to what we have in Step 1 above.)
CP = Cost of preferred stock = 9.3%, 0.093
CD = Before-tax cost of debt = 8.2%, or 0.082
T = Tax rate = 40%, or 0.40
Substituting the values into equation (2), we have:
WACCE = (0.36 * 0.142) + (0.06 * 0.093) + (0.58 * 0.082 * (1 - 0.40))
WACCE = 0.085236, or 8.5236%
Rounding to 2 decimal places, we have:
WACCE = 8.52%
Step 3: Caculation of 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.
This can be calculated as follows:
Percentage by which WACC is higher = WACCE - WACCR
Percentage by which WACC is higher = 8.52% - 7.88%
Percentage by which WACC is higher = 0.64%
Therefore, Turnbull’s weighted average cost of capital (WACC) will be higher by 0.64% if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings.