Calculating WACC: Mullineaux Corporation has a target capital structure of 70 pe

Question

Calculating WACC:

Mullineaux Corporation has a target capital structure of 70 percent common stock, 5 percent preferred stock, and 25 percent debt. Its cost of equity is 11 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.

What is Mullineaux’s WACC?

The company president has approached you about Mullineaux’s capital structure. He wants to know why the company doesn’t use more preferred stock financing because it costs less than debt. What would you tell the president?

Explanation / Answer

WACC = rD (1- Tc )*( D / V )+ rE *( E / V )

Where...

rD = The required return of the firm's Debt financing
(1-Tc) = The Tax adjustment for interest expense
(D/V) = (Debt/Total Value)
rE= the firm's cost of equity
(E/V) = (Equity/Total Value)

WACC = 0.7*0.11 + 0.05*0.05 + 0.25*0.07*(1-0.35) = 0.0909 = 9.09%

- Companies will have to pay preferred stock first in case of desolving the company over debt, and they need to pay a higher rate of interest to the preferred stock holders over debt. Hence, the company should not use more preferred stock in financing.

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