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 7.6%, the firm's cost of preferred stock, rp, is 7.1% and the firm's cost of equity is 11.6% for old equity, rs, and 12.06% for new equity, re. 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 intermadiate calculations. % 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 intermadiate calculations. %

Explanation / Answer

a. Weight of equity We= 0.55, Weight of Debt = Wd = 0.40, Weight of preferred stock = 0.05

If it uses old equity(retained earnings), cost of equity = Re=11.6%

Cost of debt (after tax) = Rd = Cost *(!-tax rate) = 7.6*(1-0.4) = 4.56%

Cost of preferred sock = Rpf = 7.1%

Now, WACC1 = We * Re + Wd * Rd + Wpf * Rpf

WACC1 = 0.55*11.6 + 0.40*4.56 + 0.05*7.1 = 8.56%

b. Weight of equity We= 0.55, Weight of Debt = Wd = 0.40, Weight of preferred stock = 0.05

If it uses new equity(new stock issued), cost of equity = Re=12.6%

Cost of debt (after tax) = Rd = Cost *(!-tax rate) = 7.6*(1-0.4) = 4.56%

Cost of preferred sock = Rpf = 7.1%

Now, WACC2 = We * Re + Wd * Rd + Wpf * Rpf

WACC2 = 0.55*12.6 + 0.40*4.56 + 0.05*7.1 = 9.11%

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