A firm's capital structure consists of 25% debt with a pre-tax cost of 7% and an after-tax cost of 4.9%. Common equity makes up 45% of the structure and the rest is made up of preferred equity. Thepreferred stock has a coupon of 8% and is currently trading at 84% of its par value. The required rate of return on the common stock is 16.2%. The firm's WACC is ________.
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A. B. C. D.C
To get the WACC in this case, you need to have information on the cost of preferred stock. This is not necessarily equal to the coupon rate on the preferred equity.
Rather, it is the discount rate, R, that equates the present value of the perpetual payments on the preferred equity to its current price. The price of a perpetuity that pays C per year, at a discount rate of R, equals C/R. In this problem, since the preferred stock is at 84% and pays 8% coupon, we have 84% = 8%/R, giving R =
9.52%. Now, the interest payments on debt are tax-deductible but those on preferred equity are not. Hence, no tax adjustment is necessary for preferred stock but you must use after-tax cost of debt in WACC calculations. With this in mind, WACC = 0.25*4.9% + 0.45*16.2% + 0.3*9.52% = 11.37%.