The Color Spectrum uses a combination of common stock, preferred stock, and debt financing

Finance Oct 15, 2020

The Color Spectrum uses a combination of common stock, preferred stock, and debt financing. The company wants preferred stock to represent 5 percent of the total financing. It also wants to structure the firm in a manner that will produce a weighted average cost of capital of 8 percent. The aftertax cost of debt is 4.6 percent, the cost of preferred is 8.2 percent, and the cost of common stock is 10.4 percent. What percentage of the firm's capital funding should be debt financing?

Expert Solution

Computation of Weight of Debt (Wd):

WACC = Wd*Rd*(1-Tax Rate)+We*Ke+Wp*Kp

Here,

W is weights of respective portfolios

R is return on respective portfolios

Wd+We+Wp = 1

8% = Wd*4.60%+(0.95-Wd)*10.40%+0.05*8.20%

8% = Wd*4.60%+9.88%-10.40%*Wd+0.41%

8% = 10.29% - 5.80%*Wd

5.80%*Wd = 10.29% - 8%

Wd = 2.29% / 5.80%

Wd = 39.48%

So, Weight of debt, Wd is 39.48%.

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