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Bonnie Lam is a credit analyst at the well-known bank J.P. Morgan Chase. She is analyzing the financlal statements of Madison, Inc., a prominent corporate
Bonnie Lam is a credit analyst at the well-known bank J.P. Morgan Chase. She is analyzing the
financlal statements of Madison, Inc., a prominent corporate client, and borrower from the bank. In
particular, she is working to compute Madison's Debt/Equity ratio. Madison's sources of funds
include $5 Million in Liabilities (debt), $2 Million in Preferred Stock, and $10 Million in Common
Equity. From the perspective of the bank, should Bonnie consider the amount of Preferred Stock as
Debt or as Equity? Justify your answer.
A company's funding consists of debt and equity (assume no preferred stock or other forms of hybrid
funding). We have learned that the after-tax cost of debt is significantly lower than the after-tax cost
of equity. We also know that a company's objective is to minimize its WACC.
Therefore, would it make sense for a company to be funded primarily (e.g., 80% or 90%) with debt to
minimize its WACC? Explain in detail.
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