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 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. If its current tax rate is 40%, how much higher will Tumbull's weighted average cost of capita (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of rasing the funds through retained earnings?

Explanation / Answer

The weighted average cost of capital can be calculated with the use of following formula:

WACC = After-Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

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WACC with Retained Earnings:

Using the information provided in the question in the above formula, we get

WACC = 11.1%*(1-40%)*45% + 12.2%*4% + 14.7%*51% = 10.98%

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WACC with New Common Stock :

Using the information provided in the question in the above formula, we get

WACC = 11.1%*(1-40%)*45% + 12.2%*4% + 16.8%*51% = 12.05%

__________

With the use of new common stock, the Turnbull's WACC will be higher by 1.07% [12.05% - 10.98%].

Answer is 1.07% (which is Option D)

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Part B)

The weighted average cost of capital can be calculated with the use of following formula:

WACC = After-Tax Cost of Debt*Weight of Debt + Cost of Preferred Stock*Weight of Preferred Stock + Cost of Equity*Weight of Equity

Weight of Debt = Value of Debt/Total Investment

Weight of Preferred Stock = Value of Preferred Stock/Total Investment

Weight of Equity = Value of Equity/Total Investment

__________

Using the information provided in the question in the above formula, we get

WACC = 750,000/1,708,000*9.6%*(1-40%) + 78,000/1,708,000*10.7% + 880,000/1,708,000*13.5% = 9.97% (answer)

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