Barton Industries expects that its target capital structure for raising funds in

Question

Barton Industries expects that its target capital structure for raising funds in the future for its capital budget will consist of 40% debt, 5% preferred stock, and 55% common equity. Note that the firm's marginal tax rate is 40%. Assume that the firm's cost of debt, rd, is 7.3%, the firm's cost of preferred stock, rp, is 6.8% and the firm's cost of equity is 11.3% for old equity, rs, and 11.86% for new equity, re.

a.)What is the firm's weighted average cost of capital (WACC1) if it uses retained earnings as its source of common equity? Round your answer to 3 decimal places. Do not round Intermediate calculations.

b.)What is the firm’s weighted average cost of capital (WACC2) if it has to issue new common stock? Round your answer to 3 decimal places. Do not round Intermediate calculations

Explanation / Answer

a. The firm's weighted average cost of capital (WACC1) if it uses retained earnings as its source of common equity

0.34

(WACC1) = 9.475 %

Note:- Assuming Cost of debt 7.3 % given in the question is after-tax only. Therefore, tax is not separetely deducted by me in cost of debt. Alternatively, You can also take cost of debt as 7.3 (1 - 0.40) = 4.38 by assuming that cost of debt (7.3 %) given in the question is Pre-tax . If You take cost of debt as 4.38 % then The firm's weighted average cost of capital (WACC1) will be:-

WACC = (0.40 * 4.38) + (0.05 * 6.8) + (0.55 * 11.3) = 8.307 %

b. The firm’s weighted average cost of capital (WACC2) if it has to issue new common stock:-

0.34

WACC2 = 9.783 %

Note:- Assuming Cost of debt 7.3 % given in the question is after-tax only. Therefore, tax is not separetely deducted by me in the cost of debt. Alternatively, You can also take cost of debt as 7.3 (1 - 0.40) = 4.38 by assuming that cost of debt (7.3 %) given in the question is Pre-tax . If You take cost of debt as 4.38 % then The firm's weighted average cost of capital (WACC2) will be:-

(WACC2) = (0.40 * 4.38) + (0.05 * 6.8) + (0.55 * 11.86) =8.615 %

Source Weight (1) Cost (2) (1) * (2) [weighted cost] Debt 0.40 7.3 2.92 Preferred sock 0.05 6.8

0.34

Common equity 0.55 11.3 6.215 Total 9.475

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