Mullineaux Corporation has a target capital structure of 60 percent common stock

Question

Mullineaux Corporation has a target capital structure of 60 percent common stock, 5 percent preferred stock, and 35 percent debt. Its cost of equity is 12 percent, the cost of preferred stock is 5 percent, and the pretax cost of debt is 7 percent. The relevant tax rate is 35 percent.

A) What is Mullineaux's WACC

B) The company president has approached you about Mullineaux's Capital sturcuture. He wants to know why the company doesn't use more preferred stock financing becuase it costs less than debt. What would you tell the president?

Explanation / Answer

A) Mullineaux's WACC is 9.0425%

B) The company does not use more preferred stock since the ultimate cost of debt is lower than that of preferred stock. This is because of the interest tax shield enjoyed by the company because of having debt in its capital structure. While the cost of preferred stock is 5%, the after tas cost of debt is lower at 0.07 (1-0.35) = 0.0455

or 4.55%.

Source of capital Weights Specific cost of capital Weighted average cost of capital Common stock 0.60 0.12 0.072 Preferred stock 0.05 0.05 0.0025 Debt 0.35 0.0455 0.015925 0.090425

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