Mullineaux Corporation has a target capital structure of 60% common stock, 5% pr
ID: 2669511 • Letter: M
Question
Mullineaux Corporation has a target capital structure of 60% common stock, 5% preferred stock, and 35% debt. Its cost of equity is 14%, the cost of preferred stock is 6%, and the cost of debt is 8%. The relevant tax rate is 35%.Part 1) What is Mullineaux’s WACC?
Part2.) The company 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?
I need help double-checking my homework please help if you can. This is all one problem, there are two parts to the problem but this is one problem. Please also show how you arrived at the answer and everything.
Explanation / Answer
Answer to P2:
The common answer as to why debt financing is more favorable than equity financing is that interest on debt is tax deductible while dividends (common and preferred) are not tax deductible for the corporation, which lowers the real cost of financing. Therefore, debt financing can cost much less than issuing more shares of stock in the long run. In addition to this, debt financing does not dilute the corporations ownership, while issuing more shares does.
So in this case, the cost of debt is 8% and the cost of pref. stock is 6% and the relative tax rate is 35%.
We assume the percentages they give us are the percentage of the actual cost relative to the amount borrowed.
Say they need to come up with 100,000. Offering more preferred stock would cost them $6,000(100,000x6%), plus the possibility of dividends which are not mentioned. Getting the money from debt would cots them 8,000 (100,000x8%). But since the debt financing expenses unrelated to he actual principle are tax deductible, they are really only paying 5200 (8,000x.35=2800 tax deduction). So despite what the president believes the debt rout is indeed cheaper than offering stock, after the tax deduction.
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