# Cost of Capital (WACC)

The CFO has asked you to recompute the ABC's weighted average cost of capital based upon three different financing scenarios. Tax rate of 40%.

Current financial structure is \$4,500,000 debt at an average interest rate of 8.5% and common equity of \$2,500,000 with a required return of 16%.

Scenario 1 is to add \$1,500,000 of debt that will cost 12%.

Scenario 2 is to add \$1,000,000 of debt at 10.25% and \$500,000 of equity at 16%.
Scenario 3 is to add \$500,000 of debt at 9%, \$500,000 of preferred stock that will return 12% and \$500,000 of equity to return 16%. There are no floatation costs.

#### Solution Preview

...,000.
= (\$4,500,000 + \$1,500,000) + \$2,500,000 = \$8,500,000
The target proportions of debt (wd) = (4,500,000 + 1,500,000) / 8,500,000 = 0.7059
The target proportions of common equity (wc) =2,500,000 / 8,500,000 = 0.29412

WACC = wd rd (1 - T) + wp rp + wcrs
= 0.7059 (12%) (1 - 0.4) + 0 + 0.29412(16%)
= 0.7059 (12%) (0.6) + 0 + 0.29412(16%)
= 5.082% + 0 + 4.7059%
= 9.788%

Scenario 2:

Total new finances are (\$4,500,000 + \$1,000,000) debt and common equity of (\$2,500,000 + \$500,000)
= (\$4,500,000 + \$1,000,000) + ...