Turnbull Co. has a target capital structure of 45% debt; 4% preferred stock, and

Question

Turnbull Co. has a target capital structure of 45% debt; 4% preferred stock, and 51% 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?

Explanation / Answer

WACC if common equity is through retained earnings = 0.45*8.2%*(1-40%) + 0.04*9.3% + 0.51*12.4% = 8.91%. WACC if common equity is through new common stock = 0.45*8.2%*(1-40%) + 0.04*9.3% + 0.51*14.2% = 9.828%. So increased WACC = 9.828%-8.91% = 0.918%

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