Question

Peter Johnson, the CFO of Homer Industries, Inc is trying to determine the Weighted Cost of Capital (WACC) based on two different capital structures under consideration to fund a new project. Assume the company’s tax rate is 30%.
Component Scenario 1 Scenario 2 Cost of Capital Tax Rate
Debt $5,000,000.00 $2,000,000.00 8% 30%
Preferred Stock 1,200,000.00 2,200,000.00 10%
Common Stock 1,800,000.00 3,800,000.00 13%
Total $8,000,000.00 $8,000

Answer 1

Answer:

Scenario 1 has WACC of 7.93%

Scenario 2 has WACC of 10.33%

Step-by-step explanation:

WACC=Ke*E/V+Kp*P/V+Kd(after tax)*D/V

Ke is the cost of equity =13%

Kp is the cost of preferred stock=10%

Kd(after tax) is the cost of debt of 8% adjusted for tax as below:

Kd(after tax )=Kd(before tax)*(1-t)

t is the tax rate of 30% or 0.3

Kd(after tax)=8%*(1-0.3)=5.60%

E is equity value,which is $1.8 million under scenario 1 and $3.8 under scenario 2

P is the value of preferred stock which is $1.2 million and $2.2 million respectively

D is the value of debt which is $5 million and $2 million

V=total value of capital structure=$8 million in both cases.

Scenario 1 WACC

WACC=13%*1.8/8+10%*1.2/8+5.6%*5/8=7.93%

Scenario 2 WACC

WACC=13%*3.8/8+10%*2.2/8+5.6%*2/8=10.33%