Question

King’s Corp has determined that its before-tax cost of debt is 9.0%. Its cost of preferred stock is 12.0%. Its cost of internal equity is 15.0%, and its cost of external equity is 17.0%. Currently, the firm's capital structure has $600 million of debt, $50 million of preferred stock, and $350 million of common equity. The firm's marginal tax rate is 40%. The firm is currently making projections for next period. Its managers have determined that the firm should have $100 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital (WACC) at a total investment level of $250 million?

Answer 1

Before-tax cost of debt = 9%

Cost of Preferred Stock = 12%

cost of internal equity = 15.0%

cost of external equity = 17.0%

Capital structure	Amount on millions of $	Weights
Debt	600	0.60
Preferred Stock	50	0.05
Common Equity	350	0.35
	1000	1

Total Investment level for next period = $ 250 million

The firm will finance the Investment by using the existing capital Structure weights.

Value of Debt in new Investment = $ 250 million*0.60 = $150 million

Value of Prefered Stockin new Investment = $ 250 million*0.05 = $12.5 million

Value of Common EQuity in new Investment = $ 250 million*0.35 = $87.5 million

Since, the firm's managers have determined that the firm should have $100 million available from retained earnings for investment purposes next period and the firm needed $ 87.5 million for investment purpoeses.

This means that the firm can finance its Common Equity from Internal Financing thus for calculating WACC of total Investment for Common Equity portion Cost of Internal equity will be taken.

- WACC= (Weight of Debt)(Cost of Debt)(1-Tax Rate) + (Weight of Prefered Stock)(Cost of Prefered Stock) + (Weight of Equity)(Cost of Equity)

WACC = (0.60)(9%)(1-0.40) + (0.05)(12%) + (0.35)(15%)

WACC = 9.09%

So, WACC of total Investment of $250 million is 9.09%