Evans Technology has the following capital structure.
Debt ............................................ 40%
Common equity .......................... 60
The aftertax cost of debt is 6 percent, and the cost of common equity (in the form of retained earnings) is 13 percent.
a)What is the firm’s weighted average cost of capital?
b)An outside consultant has suggested that because debt is cheaper than equity, the firm should switch to a capital structure that is 50 percent debt and 50 percent equity. Under this new and more debt-oriented arrangement, the aftertax cost of debt is 7 percent, and the cost of common equity (in the form of retained earnings) is 15 percent. Recalculate the firm’s weighted average cost of capital.
c)Which plan is optimal in terms of minimizing the weighted average cost of capital? Why?
To calculate the weighted average cost of capital (WACC), we need to consider the weights and costs of each component of the capital structure.
a) Calculation of WACC with the initial capital structure:
Given:
Debt = 40%
Common equity = 60%
Cost of debt (after tax) = 6%
Cost of common equity (retained earnings) = 13%
To calculate the WACC, we use the weighted average formula:
WACC = (Weight of Debt * Cost of Debt) + (Weight of Common Equity * Cost of Common Equity)
Substituting the given values:
WACC = (0.4 * 0.06) + (0.6 * 0.13)
WACC = 0.024 + 0.078
WACC = 0.102 or 10.2%
b) Calculation of WACC with the proposed capital structure:
Given:
Debt = 50%
Common equity = 50%
Cost of debt (after tax) = 7%
Cost of common equity (retained earnings) = 15%
Using the same formula as before:
WACC = (Weight of Debt * Cost of Debt) + (Weight of Common Equity * Cost of Common Equity)
Substituting the given values:
WACC = (0.5 * 0.07) + (0.5 * 0.15)
WACC = 0.035 + 0.075
WACC = 0.11 or 11%
c) To determine which capital structure is optimal in terms of minimizing the WACC, we compare the WACC values calculated in parts a) and b).
In this case, the initial capital structure with 40% debt and 60% common equity has a lower WACC of 10.2% compared to the proposed capital structure with 50% debt and 50% common equity, which has a WACC of 11%.
Therefore, the initial capital structure with 40% debt and 60% common equity is optimal in terms of minimizing the weighted average cost of capital. The reason is that the overall cost of capital is lower when the company utilizes a higher proportion of equity, as the cost of equity is generally higher than the cost of debt.