Question

9. Calculating WACC (LO3) Peacock Corporation has a target capital structure of 70 percent common stock, 5 percent preferred stock, and 25 percent debt. Its cost of equity is 11 percent, the cost of preferred stock is 5 percent, and the cost of debt is 7 percent The relevant tax rate is 35 percent a. What is Peacock's WACC? b. The company president has approached you about Peacock's capital structure. He wants to know why the company doesn't use more preferred stock financing because it costs less than debt. What would you tell the president?

Answer 1

Point A)    Formulae for Calculating WACC:

WACC

=

E

×

re

+

D

×

(1 − t)

×

rd

+

P

×

rp

(E+D+P)

(E+D+P)

(E+D+P)

Where:

E	=	Market value of equity
D	=	Market value of debt
P	=	Market value of preferred stock
re	=	Cost of equity
rd	=	Cost of debt
rp	=	Cost of preferred stock
t	=	Marginal tax rate

Assume Total Inflow of		100,000 $
Particulars	Share	Interest Rate Pre Tax	Interest Rate Post Tax	Inflow
Equity	70%	11%	11%	70,000
Preferred Stcok	5%	5%	5%	5,000
Debt	25%	7%	4.55%	25,000

WACC =   (70000/100000)*11%+(5000/100000)*5%+(25000/100000)*4.55%

WACC   of Mullineaux’s Corporation is = 9%

Point B)   

If he uses Debt in place of preferred cost he will get benefit of Interest expenses on Debt as a allowable deduction for Income/ Corporation Tax computation.

So benefit of using the source as Debt was Post Tax Cost for the company which is less than Cost of Preferred Stock.