Question

2. Washington Corporation has the following capital structure. The company's before-tax cost of debt is 8 % The company's cost of preferred stock is 10%. The company's cost of common equity is 14.5 %. The company's tax rate is 30% . Debt Preferred Stock Capital Structure (in millions) $2,000 500 Common Equity Total 2.500 $5,000 a. What are weights for the capital structure? b. What is the company's WACC? c. If the company has the following proposed independent projects that are of the same risk as the firm explain which projects should be selected. What is the optimal capital budget? Project IRR Cost of Project $4 milion $1 milion $3 million 55milion 12%6 11%6 20% A B C D

Answer 1

Solution:- Part a : Weight for the capital structure Capital Structure Weight (millions) Debt 2000 0.4000 Preferred stock 500 0.1000 Common equity 2500 0.5000 Total 5000 where, weight of capital structure = Amount of capital structure Total Amount Part b: Company's WACC Debt Preferred stock Common equity Total Before - Weight tax cost 0.4000 8.00% 0.1000 10.00% 0.5000| 14.50% After-tax weight X After cost tax cost 5.60% 2.24% 10.00% 1.00% 14.50% 7.25% 10.49% After tax cost of Debt = Before tax cost of debt X(1 - Tax Rate) = 8% X (1-0.3) = 5.6% After tax cost of Preferred stock and common equity is same as before tax cost as no tax deduction is allowed for these expenses that is preference dividend, equity dividend, etc. Hence, Company's WACC is 10.49% Part c: Independent proposal to be selected Project A or B can be selcted, as company's WACC is less than IRR for these project. If there are capital restriction then Project A must be selected as it has highest IRR. Optimal capital budget is the total amount of budgeted capital amount where marginal cost of capital is less than or equal to Internal rate of return of the project.