At the end of Year 1, your company has $10M in debt, $3M of preferred shares on the balance sheet, and $5M of common stock on the balance sheet. The market value of the common shares is $7.00 per share with 1 million shares outstanding. In year 1, the cost of debt is 6%, the cost of common equity is 10%, and preferred shares has a rate of 7%. The tax rate is 25%. In year 2, your company issues 500,000 of new shares at $6 per share, using half of this amount to reduce your debt load on the day of issuance. Assume no issuing costs. At the end of year 2, the stock price is $9 per share. Your cost of debt, cost of equity, and preferred share rate are the same as Year 1, but your tax rate has decreased to 20%.
A) What is your company’s weighted average cost of capital (WACC) at the end of Year 1?
B) What is your company’s WACC at the end of Year 2?
C) Using Part A and Part B as a reference, what are the pros and cons of equity financing and the effect on WACC?