Question

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.

Required:
a. What is Mullineaux’s WACC?
b. 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?

Answer 1

Answer:

a. What is Mullineaux’s WACC?

• 9.09%

b. 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?

• He is wrong because the after tax cost of debt is 4.55% which is lower than the cost of preferred stocks (5%). Interests related to debt are tax deductible but preferred dividends aren't.  

Explanation:

capital structure:

• 70% common stock
• 5% preferred stock
• 25% debt

cost of equity 11%

cost of preferred stock 5%

cost of debt 7%

tax rate 35%

WACC = (0.7 x 11%) + (0.05 x 5%) + [0.25 x 7% x (1 - 35%)] = 7.7% + 0.25% + 1.1375% = 9.0875% = 9.09%

after tax cost of debt = 7% x (1 - 35%) = 4.55%