Question

Turnbull Co. has a target capital structure of 45% debt, 4% preferred stock, and 51% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2%. If Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.8%. If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? (Note: Round your intermediate calculations to two decimal places.)

Answer 1

Answer:

TurnBull's Weighted Average cost of capital is higher by 1.07% if the used common Equity to raised the capital.

Explanation:

First, using the WACC formula and using Retained earnings cost of Capital. we get the following outcome.

WACC = Debt W x after tax cost of Debt + Preferred Stock weight x Cost of capital + Equity W x Cost of Capital

WACC = 45% x 8.33% + 4% x 12.20% + 51% x 14.70% =

WACC = 3.75% + 0.49% + 7.50% = 11.73%

Second, using the WACC formula and using common equity cost of Capital. we get the following outcome.

WACC = Debt W x after tax cost of Debt + Preferred Stock weight x Cost of capital + Equity W x Cost of Capital

WACC = 45% x 8.33% + 4% x 12.20% + 51% x 16.80% =

WACC = 3.75% + 0.49% + 8.57% = 12.80%

Increase Cost using common equity over Retained earnings is (12.80% - 11.73% ) = 1.07%

Answer 2

If its current tax rate is 25%, how much higher will Turnbull’s weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the funds through retained earnings? The answer is  1.07%

Explanation:

The Weighted Average Cost of Capital is the discount rate for calculating the Net Present Value (NPV) of a business.  WACC is calculated by multiplied the cost of each capital source (debt and equity) by relevant weight, then adding the products together to determine the value.  

Then the cost of retained earnings approximates the return that investors expect to earn on their equity investment in the company

Whereas the cost of equity is the return a firm theoretically pays to its equity investors for the risk they undertake by investing their capital

We used the WACC formula and retained earnings cost of capital.

WACC = debt W * after tax cost of debt + preferred stock weight x cost of capital + equity W * cost of capital

WACC = 45% x 8.33% + 4% x 12.20% + 51% x 14.70%

WACC = 3.75% + 0.49% + 7.50% = 11.73%

Then we used the WACC formula and common equity cost of capital

WACC = debt W * after tax cost of debt + preferred stock weight x cost of capital + equity W x cost of capital

WACC = 45% x 8.33% + 4% x 12.20% + 51% x 16.80% =

WACC = 3.75% + 0.49% + 8.57% = 12.80%

Therefore the increasing of cost using common equity over retained earnings is:

12.80% - 11.73% = 1.07%

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