Cost Components of a Company's Capital Structure
1. b. Because WACC is a blended cost of capital, it is used to discount or capitalize returns to all invested capital.
2. d. To get the after-tax cost of debt, the pretax cost of debt must be tax-affected. Answers (a), (b), and (c) are all pretax.
True or Faise Questions
3. False, In this case, the company's actual amount of debt and equity in its capital structure may be appropriate. This is because a minority stockholder would not be able to change tlie capital structure of the company.
4. True
Fill-in-the-Blank Questions
5. Market; book
6. Net
7. Iterative (repetitious)
8. Underestimate; overvalue
Exercises
9. b. Because the market price per share for tlie preferred stock is S16.00 and its dividend per share is $2.40 per share per year, tlie cost of preferred equity is $2.40/$16.00 = 0,15 or 15%,
10. d. In the return to tlie debt component, interest is a tax-deductible expense to a corporate taxpayer. One way to approximate the cost of debt after taxes or net of the tax effect is to multiply (he cost of debt before tax by (1 - lax rate): 10% x (1 - 0.40) = 0.10 x 0.60 = 6%.
11. The capital structure weights arid the can he computed as follows:
of invested capital for Company XYZ
Component
Amount
Component Total
V" eight
Common stock 4,000,000 |
$10 |
$40,000,000 |
50% |
|
Preferred stock 2,000,000 |
$16 |
$32,000,000 |
40% |
|
Debt $10,000,000 |
0.80 |
$8,000,000 |
10% |
|
Market value of invested capital: |
£80,000,000 |
100% |
||
12. |
d. The formula for calculating WACC is: |
WACC = (ke x We) + (k7?x Wp) + \kd(v!) (1 - I) x Wd]
= (25% x 0.50) + (15% x 0.40) + [10% (1 - 0.40) x 0.10] = 12.5%+ 6%+ 0.6% = 19.10%
Or, setting this in tabular form:
Component
..QSt
Weight
Veighted. cost
Common stock Preferred stock Debt (after tax)
Weighted average cost of capital Capital structure:
25%
15%
6%
0.50 0.40 0.10
2.5%
6.0% 0.6%
Component |
Amount |
Price |
Component total |
|||
Common stock |
1,000,000 shares |
£7.0 |
£7.000.000 |
57.1%. |
||
Preferred slock |
500,000 shares |
$4.5 |
$2,250,000 |
184% |
||
Debt; |
$3,000,000 |
24.5% |
||||
Total: |
$12,250,000 |
100.0% |
||||
Component |
Cost |
We |
igbl. |
Weighted Cost. |
||
Common stock |
0.20 |
X |
0.5' |
71 = |
0.114 |
|
Preferred stock |
0.09 |
X |
0.1: |
34 = |
0.017 |
|
Debt 0.10 x (1- |
0.30) = 0.07 |
X |
0.245 = |
0.017 |
||
1.00
0.148
14.8%
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Cost Components of a Company's Capital Structure