You are the CFO of Megatron Industries. You have $53.9 million in LTD, $7.7 in p
ID: 2661040 • Letter: Y
Question
You are the CFO of Megatron Industries. You have $53.9 million in LTD, $7.7 in preferred stock and $15.4 million in common equity. The weights for the current capital structure are 70% debt, 10% preferred, 20% common equity. You are considering a major project which would add $23 million to the capital structure:
tructure A: $70 million LTD, $10 million preferred, $20 million common
Structure B: $53.9 million LTD, $7.7 million preferred, $38.4 million common
Structure C: $ 53.9 million LTD, $ $30.7 million preferred, $15.4 million common
Cost: Current structure: 2.9% debt, .54% preferred stock, and 6.46% equity
New structure: 2.12% debt, 1.09% preferred, 7.2% equity
Determine which structure is best and defend your response.
Explanation / Answer
RESPONSE: STRUCTURE C IS THE BEST
REASON: IT LEADS TO LEAST COST OF CAPITAL (therefore in line with the objective of shareholders' wealth maximisation)
EXPLANATION:
Current structure and the cost of capital is shown below
Column "weight" in the above table represents the capital structure ie how much proportion is LTD, preferred stock and common stock respectively
Column "cost" shows the respective costs of debt, preferred stock and equity.
and last column "WACC" shows the overall cost of capital for the firm given the structure. It is calculated as the weighted average of costs of equity debt and preferred stock ie sum product colums 2 and 3
Formulating similar tables for other structures
As we can see that WACC is least for structure C, it will result in maximum shareholder wealth amongst the three.
Mathematically since this is the smallest number and is used for discounting in the denominator this will result in the maximum NPV
Thats why structure C is the best.
Current weight cost WACC LTD 53.9 70% 2.90% Preferred 7.7 10% 0.54% 3.37600% Common 15.4 20% 6.46%Related Questions
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