Jones Company has a target capital structure of 30% debt,15% preferred stock,and 55% common equity.The company's after-tax cost of debt is 7%,its cost of preferred stock is 11%,its cost of retained earnings is 15%,and its cost of new common stock is 16%.The company stock has a beta of 1.5 and the company's marginal tax rate is 35%.What is the company's weighted average cost of capital if retained earnings are used to fund the common equity portion?
A) 11.20%
B) 12.00%
C) 13.80%
D) 14.45%

Question

Quizplus · Accepted Answer

Step 1: Calculate the cost of each component.

Cost of Debt = 7%
Cost of Preferred Stock = 11%
Cost of Retained Earnings = 15%
Cost of New Common Stock (using CAPM) = 7% + (1.5 * 5%) = 14%

Step 2: Calculate the weights of each component.

Weight of Debt = 30%
Weight of Preferred Stock = 15%
Weight of Common Equity = 55%

Step 3: Calculate the overall WACC.

WACC = (0.30 * 0.07) + (0.15 * 0.11) + (0.55 * 0.15) = 0.1075

Since retained earnings are used to fund the common equity portion, the cost of new common stock is not used in the calculation. Therefore, the company's weighted average cost of capital is 10.75%, which is closest to option B (12.00%).

Jones Company Has a Target Capital Structure of 30% Debt,15