Let’s suppose that a firm issues two tranches (“series”) of bonds, in addition t

Question

Let’s suppose that a firm issues two tranches (“series”) of bonds, in addition to preferred stock and retained earnings. It has so much retained earnings that it does not have to issue new equity. However, the two different tranches have different flotation costs. How does one calculate the breakpoint for the resulting two WACC’s?

A. Dollar amount of lower cost tranche divided by the We.

B. Dollar amount of lower cost tranche divided by the Wd.

C. Dollar amount of higher cost tranche divided by the Wd.

D. There will not be a breakpoint since there will only be one WACC.

Please explain.

Explanation / Answer

D. There will not be a breakpoint since there will only be one WACC.

Reason:- WACC is the overall cost of total capital of the firm. It is the weighted average of the cost of different sources of fund. WACC of any portfolio consisting of varieties of securities (Debt, equity etc.) will one only calculated as shown below. So,there will not be a breakpoint since there will only be one WACC.

WACC = (Ke * Weight) + (Kd * Weight) + (Kp * Weight) + (Kr * Weight)

Ke = Cost of equity

Kd = Cost of debt

Kp = Cost of preferred stock

Kr = Cost of reserve

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