Chapter 11, Problem 12PROB

Summary Introduction

Weighted Average Cost of Capital (WACC) is the required rate of return investors would expect from the company. If a company uses a combination of financing alternatives to fund its business, it should calculate an average cost of capital. Various long-term funds include debt, equity and preferred stock. Regardless of the mode of financing for a project, a company’s WACC should be considered in making capital budgeting decisions.

An optimal capital structure of a company is a mix of debt, equity and preferred stock which can be used to maximize the company’s stock price. Therefore, a target proportion of capital structure and cost of each financing can be used to determine the WACC of the company.

$WACC=w_d\left(r_{dT}\right)+w_{ps}\left(r_{ps}\right)+w_s\left(r_{s}or{r}_e\right)$

Here,

Proportion of debt in the target capital structure “$w_d$”

Proportion of preferred stock in the target capital structure “$w_{ps}$

Proportion of equity in the target capital structure “$w_s$”

After tax cost of debt, preferred stock, retained earnings and new equity is “$r_{dT}$”,“$r_{ps}$”,“$r_s$”and “$r_e$”, respectively.

Breakpoint is the value of the new capital that can be raised just before an increase in the firm’s weighted average cost of capital.

$\text{Break-point}=\frac{\left(\begin{array}{l}\text{Maximum amount of lower cost }\\ \text{of capital of a given type}\end{array}\right)}{\left(\text{Proportion of that type of capitalinthecapitalstructure}\right)}$

The company plans new expansion which would require issuing new debt and equity. The capital structure requires debt proportion of 60%. Cost of debt for amount of debt issued $1-$450,000 is 4.5%, $450,001-$750,000 is 5.8% and over $750,001 is 6.5%.