3.8 WACC Practice Problem
You are given the following problem. What is the firm’s WACC?
LCM Corp.
As of 12.31.20XX
(000)
| Long-Term Debt (LTD) | $250,000 | Corporate Tax Bracket | 21% |
| Preferred Stock | 50,000 | Interest Rate in Debt | 5% |
| Common Stock @ Par | 300,000 | Cost of Preferred Stock | 7% |
| Additional Paid-in-Capital | 10,000 | Cost of Retained Earnings | 10% |
| Retained Earnings | 500,000 | Cost of Common Stock | 12% |
| Total Equity + LTD | $1,110,000 | ||
Solution: Here is the formulation – do you agree? YOU do the calculation!
WACC = (250/1,110) (.05) (1-.21) + (50/1,110) (.07) + (310/1,110) (.12) + (500/1,110) (.10)
= ???
Question: What happens to the WACC if the firm raises more debt capital to fuel growth? Assume ceteris paribus.
Note: “Pecking Order Theory” asserts that firms will raise capital first from its least costly source. Thus, external equity, if this theory is applied, will be raised only if internal equity is insufficient.
(The answer to the problem above is: WACC = 0.0906. Don’t tell anybody!)
