Hi, I already have the answers to this question but would like to ask for furthe

Question

Hi,

I already have the answers to this question but would like to ask for further explanation on one part of the question (part c)

I need to know why. Thank you very much!

It is from Foundations of Financial Management 15th edition, chapter 11, problem 20

Here is the question + answers;

Evans Technology has the following capital structure.

Debt ............................................ 40%

Common equity .......................... 60

The aftertax cost of debt is 6 percent, and the cost of common equity (in the form of retained earnings) is 13 percent.

a) What is the firm’s weighted average cost of capital?

The weighted average cost of capital for Evans Technology is 10.2%.

b) An outside consultant has suggested that because debt is cheaper than equity, the firm should switch to a capital structure that is 50 percent debt and 50 percent equity. Under this new and more debt-oriented arrangement, the aftertax cost of debt is 7 percent, and the cost of common equity (in the form of retained earnings) is 15 percent. Recalculate the firm’s weighted average cost of capital.

The recalculated weighted average cost of capital for Evans Technology is 11%.

c) Which plan is optimal in terms of minimizing the weighted average cost of capital? Why?

The minimum weighted average cost of capital (WACC) has to be taken into consideration in order to have the profit.

In Plan 1 at 6% debt and 13% common equity, there is a return of 10.2%.

Consequently, in Plan 2 at 7% debt and 15% common equity, there was a return of 11%.

Therefore, Plan 1 has is optimal in terms of minimizing the weighted average cost of capital as it has a lower average than Plan 2.

Explanation / Answer

PLAN A IS OPTIMAL IN TERMS OF MINIMISING THE WEIGHTED AVERAGE COST OF CAPITAL

AS IN PLAN A THE WEIGHT OF THE FIXED INTEREST DEBT IS LESS WHICH IS INCREASED TO 50% IN PLAN B AND THE WEIGHT OF EQUITY WHOSE COST IS IN THE FORM OF RETAINED EARNINGS WAS 60% IN PLAN A.HENCE WEIGHTED AVERAGE COST OF CAPITAL WAS LOWER IN PLAN A.

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