Copernicus Inc. has determined that its target capital structure will
be 60% debt, 10% preferred stock, and 30% common stock. As the
financial manager, the CFO has informed you that the company?s before
tax cost of debt is 10%, preferred stock is 14%, and common stock is
16%. In addition, the company?s marginal tax rate is 40%. Based on the
information provided, calculate the weighted average cost of capital
(WACC).

Hi!!


"...the assets of a company are financed by either debt or equity.
WACC is the average of the cost of each of these sources of financing
weighted by their respective usage in the given situation. By taking a
weighted average, we can see how much interest the company has to pay
for every dollar it borrows.
A firm's WACC is the overall required return on the firm as a whole.
It is the appropriate discount rate to use for cash flows similar in
risk to the overall firm."
"Weighted Average Cost of Capital - WACC"
http://www.investopedia.com/terms/w/wacc.asp


To calculate WACC you must multiply the cost of each capital component
by its proportional weight and then summing, so if we call:
Rp = cost of preferred stock
Re  = cost of equity (common stock)
Rd  = cost of debt
E = market value of equity
D = market value of debt
P = market value of preferred stocks
V = D + E + P
E/V = percentage of equity
D/V = percentage of debt
P/V = percentage of preferred stock
T = firm's tax rate

Then WACC is:

WACC = (D/V)*Rd*(1-T) + (E/V)*Re + (P/V)*Rp

Note that we are using after tax rates, but Re and Rp are not affected
by taxes so the only term affected are debt:
After Tax cost of debt = Rdt = Rd*(1-T)

Then WACC's formula can be expressed as:
WACC = (D/V)*Rdt + (E/V)*Re + (P/V)*Rp

Where all rates are after tax rates.


This problem assumes that:
Rp = 0.14
Re  = 0.16
Rp = 0.10
E/V = 0.30
D/V = 0.60
P/V = 0.10
T = 0.40

so WACC is:

WACC = D/V)*Rd*(1-T) + (E/V)*Re + (P/V)*Rp =
     = (1-0.40)*0.60*0.10 + 0.30*0.16 + 0.10*0.14 =
     = 0.036 + 0.048 + 0.014 =
     = 0.098 = 9.80%

The Corpernicus'WACC is 9.8%


I hope that this helps you. If you need a clarification, feel free to
request for it before rate this answer.

Regards,
livioflores-ga

That was the answer that I got, but because word problems are not
exactly my strong point, I wanted a second opinion. Thanks!

I got the following answer for this problem:

WACC = [ D ÷ V x (1-Tc) rdebt] + (P ÷ V x rpreferred) + (E ÷ V x requity)

Where V= D+P+E = .60 +.10 + .30
Therefore WACC = [.60 x (1-.40) 60%] + (.1 x 10%) + (.3 x 30%)

                             = 31.6%

Which answer is correct?

buffcode, your mistake is the following:

the statement give us the following data:
D/V = 0.6
E/V = 0.3
P/V = 0.1

It does not tell us which are the values of D, E, P nor V .

If we looked at this from a percentage standpoint versus actual
numerical values we should achieve the same end result; correct? Say
if we chose $1 or one million dollars, the %s for the D/V, E/V, and
P/V would yield the same WACC percentage I believe.
 
Thoughts?