For a typical corporation, which of the following capital structures w

QUESTION

For a typical corporation, which of the following capital structures will result in the lowest weighted average cost of capital?Answer40% debt, 20% preferred stock, 40% common equity50% debt, 10% preferred stock, 40% common equity60% debt, 10% preferred stock, 30% common equity60% debt, 15% preferre
Let us assume for example,Cost of debt (Kd) = 8%Cost of equity (Ke) = 10%Cost of preferred stock (Kp) = 12%Tax rate (T) = 40se-1: The formula for calculating the WACC is WACC = Wd * Kd * (1-T) We * Ke Wp * Kpwhere Wd is the weight of debt We is the weight of equity Wp is the weight of preferred stock WACC = 0.4 * 0.08 * (1 0.4) 0.4 * 0.10 0.2 * 0.12 = 0.0192 0.04 0.24 = 0.0832 or 8.32se-2: WACC = 0.5 * 0.08 * (1 0.4) 0.4 * 0.10 0.1 * 0.12 = 0.024 0.04 0.012 = 0.076 or 7.6se-3:

ACC = 0.6 * 0.08 * (1 0.4) 0.3 * 0.10 0.1 * 0.12 = 0.0288 0.03 0.012 = 0.0708 or 7.08se-4: WACC = 0.6 * 0.08 * (1 0.4) 0.25 * 0.10 0.15 * 0.12 = 0.0288 0.025 0.018 = 0.0718 or 7.18%Therefore, among the four different cases, the debt with 60%, 30% of common equity and 10% of the Preferred stock will result in lower WACC.

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