Question

Blueprint 6.  6: The Cost of Capital: Weighted Average Cost of Capital

Quantitative Problem: 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 25%. Assume that the firm's cost of debt, rd, is 10.3%, the firm's cost of preferred stock, rp, is 9.5% and the firm's cost of equity is 12.9% for old equity, rs, and 13.2% 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? Do not round intermediate calculations. Round your answer to two decimal places.   % What is the firm’s weighted average cost of capital (WACC2) if it has to issue new common stock? Do not round intermediate calculations. Round your answer to two decimal places.   % End of chapter problems 1.  Problem 10.01 (After-Tax Cost of Debt) The Holmes Company's currently outstanding bonds have a 10% coupon and a 10% yield to maturity. Holmes believes it could issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 25%, what is Holmes' after-tax cost of debt? Round your answer to two decimal places.   %

Answer 1

WACC = After tax cost of debt*Weight of Debt + Cost of Preferred stock*weight of preferred stock + Cost of Equity*Weight of Equity

WACC1 using retained earnings = 10.3%*(1-25%)*40% + 9.5%*5% + 12.9%*55%

= 10.66%

WACC 2 = 10.3%*(1-25%)*40% + 9.5%*5% + 13.2%*55%

= 10.825%

i.e. 10.83%

After tax cost of Debt = YTM*(1-tax rate)

= 10%*(1-25%)

= 7.5%