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Calculate the firm's WACC - Q & R Manufacturing

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1. As the new chief financial officers (CFO) of Q & R Manufacturing, the chief executive officer (CEO) reminded you that you are expected to try and adjust the firm's capital structure to lower its weighted average cost of capital (WACC). He asks you to address a number of questions dealing with WACC in a report to him and the firm's board of directors.

The company's balance sheet has the following information in the liabilities and stockholder equity section:

- The common stockholders have an expected return of 12%, preferred stockholders have an expected return of 6%, and the firm's bondholders purchased the firms bonds at a yield to maturity (YTM) of 4%. The firm's tax rate is 40%.

Common stock $2,000,000
Preferred stock $3,000,000
Long-term debts (bonds) $5,000,000

Total liabilities + equity = $10,000,000

Given the previous information, address the following requirements:

- Calculate the firm's WACC.
- If, as the firm's CFO, you wished to lower the WACC, make up a set of new dollar figures using different amounts of common stock, preferred stock, and long-term debt that would lower the WACC.
- Show the calculations to demonstrate that the new capital structure has a lower WACC than the original structure.
- Explain why you may want to lower the firm's WACC.

2. Often, a person or company's expected return is expressed as an opportunity cost. In your Discussion Board posting, include the following information:
- Define and explain opportunity cost.
- Explain how opportunity cost relates to expected return.
- Provide examples from Internet articles found from a credible Web site and the link to the article.

Please include references

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Solution Summary

The expert calculates the firm's WACC for the Q&R Manufacturing.

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Weighted Average Cost of Capital
Q & R Manufacturing weighted average cost of capital (WACC) is important information more so in its capital budgeting decision making process. WACC is computed as follows:

WACC = rps x wps + rcs x wcs + rd x wd x (1 - T)

rps = cost of preferred stock
wps = weight of preferred stock
rcs = cost of common stock
wcs = weight of common stock
rd = cost of debt
wd = weight of debt
T = income tax rate

These variables as they pertain to Q & R Manufacturing are as follows:
rps = 6%
wps = $3,000,000/($2,000,000+$3,000,000+$5,000,000) = 30%
rcs = 12%
wcs = $2,000,000/($2,000,000+$3,000,000+$5,000,000) = 20%
rd = 4%
wd = $5,000,000/($2,000,000+$3,000,000+$5,000,000) = 50%
T = 40%

Therefore, by substitution, WACC is computed as
WACC = 6% x 30% + 12% x 20% + 4% x 50% (1 - 40%)
WACC = 1.8% + 2.4% + 1.2%
WACC = 5.4%

Now, assuming that the company wants to lower its WACC, the following new capital structure is assumed:
Common stock $1,000,000
Preferred stock $0
Long-term debts (bonds) $9,000,000
Total liabilities + equity = $10,000,000

Given this new capital structure, the weights of the different components of the company's capital are as follows
wps = $0/($1,000,000+$0+$9,000,000) = 0%
wcs = $1,000,000/($1,000,000+$0+$9,000,000) = 10%
wd = $9,000,000/($1,000,000+$0+$9,000,000) = 90%

Then, the company's new WACC is computed as follows
WACC = 6% x 0% + 12% x 10% + 4% x 90% (1 - 40%)
WACC = 0.0% + 1.2% + 2.16%
WACC = 3.36%

Optimal Capital Structure
Unfortunately, managing the firm's capital structure is much more than just making up a set of new dollar figures and assigning them to the different components of this structure. Fortunately, there are several sets of management ...

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