Wacc

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9Calculating WACC

Mullineaux Corporation has a target capital structure of 60 percent common stock, 5 percent preferred stock, and a 35 percent debt. Its cost of equity is 12.5 percent, the cost of preferred stock is 5.5 percent, and the cost of debt is 7.2 percent. The relevant tax rate is 35 percent.

a. What is Mullineaux’s WACC?

b. The company president has approached you about Mullineax’s capital structure. He wants to know why the company doesn’t use more preferred stock financing, since its cost less than debt. What would you tell the president?

Weighted average Cost of Capital = E/V * Cost of Equity + D/V * cost of debt * (1-tax rate)

Answer A - Mullineaux's WACC

WACC = 60%*14 + 5%*6 + 35%*8*(1-0.35)
WACC = 8.4% + 0.3% + 1.82%
WACC = 10.52%

Answer B
Lets analyse to following situations..

Situation 1 - Equity 50%, Preferred Stock 25% & Debt 25%

WACC = 50%*14 + 25%*6 + 25%*8*(1-0.35)
WACC = 7% + 1.5% + 1.3%
WACC = 9.8%

Situation 2 - Equity 60%, Preferred Stock 20% & Debt 20%

WACC = 60%*14 + 20%*6 + 20%*8*(1-0.35)
WACC = 8.4% + 1.2% + 1.04%
WACC = 10.24%

Situation 3 - Equity 60%, Preferred Stock 35% & Debt 5%

WACC = 60%*14 + 35%*6 + 5%*8*(1-0.35)
WACC = 8.4% + 2.1% + 0.26%
WACC = 10.76%

The above situation analyse effect of WACC when the capital structure is changed.

The company should use more of debt as after tax cost of debt is 5.2% only (8%*(1-0.35)). When considering option for capital structure one need to look at after tax cost of debt. Because interest expenses are tax deductible. But the preferred dividend are paid out of Net Profits after taxes. Hence the cost of debt is lower than preferred stock.
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