With a tax rate of 40% and a total capital structure of $10,000,000. We need to

Question

With a tax rate of 40% and a total capital structure of $10,000,000. We need to calculate the WACC for the following two scenarios.

A) Composition of capital sttucture

                                                  debt 10.0 % with a cost of 8%

                                preferred equity 20.0 % with a cost of 10%

                                 common equity 70.0 % with a cost of   6%

      B) Composition of capital sttucture

                                                   debt 60.0 % with a cost of 8%

                                preferred equity 10.0 % with a cost of 10%

                                 common equity 30.0 % with a cost of   3%

Which is the best for option for the company? Explain.

Explanation / Answer

After tax cost of debt = 8%(1-0.4) = 4.8%

A)

WACC = (4.8*1000000/10000000) + (10*2000000/10000000) + (6*7000000/10000000)

WACC = 0.48+2+4.2 = 6.68%

B)

WACC = (4.8*60%) + (10 * 10%) + (3 * 30%)

WACC = 2.88+1+0.9 = 4.78%

WACC is less in option B than option A

Since cost of capital is less in option B therefore it should be selected

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