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.

Required:
a. What is Mullineaux's WACC?
b. The companies 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:

Part a

10.52 %

Part b

Preferred stock dividends are not tax deductible hence they remain expensive than debt which has a tax shield

Explanation:

Mullineaux's WACC = Cost of Debt x Weight of Debt + Cost of Equity x Weight of Equity + Cost of Preferred Stock x Weight of Preferred Stock

Always use the After tax Cost of Debt for WACC calculation,

After tax Cost of Debt = Interest x (1 - tax rate)

                                     = 8.00 % ( 1 - 0.35)

                                     = 5.20 %

therefore,

Mullineaux's WACC = 5.20 % x 0.35  + 14 % x 0.60 + 6.00 % x 0.05

                                  = 10.52 %

The company doesn't use more preferred stock financing because does not have a tax shield as dividends are not tax deductible.