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Weighted average cost of capital

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5. Given the following information, calculate the weighted average cost of capital for

Situation A and Situation B:

Situation A Situation B
Capital Structure
Common Stock 55% 30%
Preferred Stock 15% 15%
Debt 30% 55%

Corporate tax rate 30% 30%
Dividend, common \$2.75 \$2.75
Price, common \$68 \$68
Dividend, preferred 10% 10%
Price, preferred \$103 \$103
Bond yield 11% 11%
Bond coupon rate 13% 13%
Flotation cost, preferred \$4.50 \$4.50
Growth rate 7.5% 7.5%

After you have calculated both weighted average cost of capital amounts, write a response that explains why the rates are different and what the advantages and disadvantages of both alternatives are.

Conclude with which capital structure you would recommend and why you selected that structure.

Solution Preview

Situation A and Situation B:

Situation A Situation B
Capital Structure
Common Stock 55% 30%
Preferred Stock 15% 15%
Debt 30% 55%

Corporate tax rate 30% 30%
Dividend, common \$2.75 \$2.75
Price, common \$68 \$68
Dividend, preferred 10% 10%
Price, preferred \$103 \$103
Bond yield 11% 11%
Bond coupon rate 13% 13%
Flotation cost, preferred \$4.50 \$4.50
Growth rate 7.5% 7.5%

WACC = Proportion of debt X after tax cost of debt + Proportion of preferred stock X cost of preferred stock + Proportion of common stock X cost of common stock

The costs are

After tax cost of debt = 11% X (1-0.3) = 7.7% (we take the yield and not the coupon rate since yield represents the current required return of the bond holders)
Cost of ...

Solution Summary

The solution explains the calculation of weighted average cost of capital for two capital structures

\$2.19