12. Stanfield Technologies has the following capital structure. Debt 45% Common
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Question
12. Stanfield Technologies has the following capital structure.
Debt 45%
Common equity 55%
The after-tax cost of debt is 7%; and the cost of common equity (in the form of retained earnings) is 14%.
a. What is the firm's weighted average cost of capital (3 points)?
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 after-tax 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 (3 points).
c. Which plan is optimal in terms of minimizing the weighted average cost of capital (2 points)?
Explanation / Answer
WACC = rD (1- Tc )*( D / V )+ rE *( E / V )
Where...
rD = After tax cost of debt
(D/V) = (Debt/Total Value)
rE= the firm's cost of equity
(E/V) = (Equity/Total Value)
a.
WACC = 45%*7% + 55%*14% = 0.1085 = 10.85%
b.
WACC = 50%*7% + 50%*15% = 0.1100 = 11.00%
c.
WACC is less for plan A. Plan A is optimal for minimizing the weighted average cost of capital.
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