Answer:
a. With New Stock = 8.307%
b. With Old stock = 7.971%
Explanation:
The weighted average cost of capital (WACC) defines the cost rate that blends the capital structure cost including equity, debt, and preferred stock.
Requirement A
If it uses retained earnings as its source of common equity,
Given,
The weight of the combination of the capital structure is -
[tex]W_{d}[/tex] = 40% = 0.40; [tex]W_{p}[/tex] = 5% = 0.05; [tex]W_{e}[/tex] = 55% = 0.55
For cost of debt, we have to find cost of debt after tax, [tex]R_{d}(1 - t)[/tex] =
6.9% x (1 - 0.40) = 4.14%
Cost of preferred stock, [tex]R_{p}[/tex] = 6.4%
Cost of new Equity, [tex]R_{e}[/tex] = 11.51%
We know, the weighted average cost of capital (WACC) =
[tex]W_{d}[/tex] x [tex]R_{d}[/tex] + [tex]W_{p}[/tex] x [tex]R_{p}[/tex] + [tex]W_{e}[/tex] x [tex]R_{e}[/tex]
= (0.40 x 4.14%) + (0.05 x 6.4%) + (0.55 x 11.51%)
= 1.656% + 0.32% + 6.3305%
= 8.307%
Requirement B
If it has to issue new common stock, the weighted average cost of capital (WACC) = [tex]W_{d}[/tex] x [tex]R_{d}[/tex] + [tex]W_{p}[/tex] x [tex]R_{p}[/tex] + [tex]W_{s}[/tex] x [tex]R_{s}[/tex]
Given,
The weight of the combination of the capital structure is -
[tex]W_{d}[/tex] = 40% = 0.40; [tex]W_{p}[/tex] = 5% = 0.05; [tex]W_{e}[/tex] = 55% = 0.55
For cost of debt, we have to find cost of debt after tax, [tex]R_{d}(1 - t)[/tex] =
6.9% x (1 - 0.40) = 4.14%
Cost of preferred stock, [tex]R_{p}[/tex] = 6.4%
Cost of new Equity, [tex]R_{s}[/tex] = 10.9%
Therefore, putting the value in the equation,
WACC = (0.40 x 4.14%) + (0.05 x 6.4%) + (0.55 x 10.9%)
WACC = 1.656% + 0.32% + 5.995%
WACC = 7.971%
