Brite Lighting Corporation wants to investigate the effect on its cost of capita

Question

Brite Lighting Corporation wants to investigate the effect on its cost of capital based on the rate at which the company is taxed. The firm wishes to maintain a capital structure of 30% debt, 10% preferred stock, and 60% common stock. The cost of financing with retained earnings is 14% (i.e., rs = 14%), the cost of preferred stock financing is 9% (rps = 9%), and the before-tax cost of debt is 11% (rd = 11%). Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts (a) to (c) below.

(a)   Tax rate = 40%.

(b)   Tax rate = 35%.

(c)    Tax rate = 25%.

Explanation / Answer

WACC=Kd*Wd+Kps*Wps+Kr*Wr

(A) Kd=11(1-0.40)=6.6

Kr=14(1-.40)=8.4

Kps=9(1-.40)=5.4

Hence, WACC=6.6*.30+8.4*.60+5.4*.10=7.56%

(B) Kd=11(1-0.35)=7.15

Kr=14(1-.35)=9.1

Kps=9(1-.35)=5.85

WACC=7.15*.3+9.1*.6+5.85*.10=8.19%

(C)) Kd=11(1-0.25)=8.25

Kr=14(1-.25)=10.5

Kps=9(1-.25)=6.75

WACC=8.25*.3+10.5*.6+6.75*.10=9.45%

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