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 14 percent, the cost of preferred stock is 6 percent, and the cost of debt is 8 percent. The relevant tax rate is 35 percent. (Do not include the percent sign (%). Round your answer to 2 decimal places. (e.g., 32.16))

(a)	Mullineaux's WACC is ______ percent.

(b)	Which of the following statement is true?

a. On an aftertax basis, debt is cheaper than the preferred stock.  

b. On an aftertax basis, preferred stock is cheaper than the debt.

Answer 1

a.The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+Wps*Kps+We*Ke

Where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.35*8%*(1 – 0.35) + 0.05*6% + 0.60*14%

            = 1.82% + 0.30% +8.40%

            = 10.52%.

b.On an after tax basis, debt is cheaper than preferred stock. The reason being that the interest paid on corporate debt is tax deductible and preference shares do not have any tax benefits like debt.

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