9. Calculating WACC [LO3] Mullineaux Corporation has a target capital structure

Question

9. Calculating WACC [LO3] Mullineaux Corporation has a target capital structure of 70 percent common stock, 5 percent preferred stock, and 25 percent debt Its cost of equity is 11 percent, the cost of preferred stock is 5 percent, and the pretax cost of debt is 7 percent The relevant tax rate 1s35 percent a. What is Mullineaus'x WACC? b. The company president has approached you about Mullineaux's capital structure. He wants to know why the company doesn't use more preferred stock financing because it costs less than debt. What would you tell the president?

Explanation / Answer

   a.     Using the equation to calculate the WACC, we find:

               WACC = .70(.11) + .05(.05) + .25(.07)(1 – .35)

               WACC = 0.090875 or 9.09%

       b.     Since interest is tax deductible and dividends are not, we must look at the aftertax cost of debt, which is:

              

               RD = .07(1-.35)

               RD = .0455 or 4.55%

       Hence, on an aftertax basis, debt is cheaper than the preferred stock.

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