After careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market value weights shown in the following table Source of capital Target market value weight Long-term debt 20% Preferred stock 13 Common stock equity 67 Total 100% The cost of debt is estimated to be 4.8%; the cost of preferred stock is estimated to be 11.7%; the cost of retained earnings is estimated to be 15.2%; and the cost of new common stock is estimated to be 17.2%. All of these are after-tax rates. The company's debt represents 15%, the preferred stock represents 8%, and the common stock equity represents 77% of total capital on the basis of the market values of the three components. The company expects to have a significant amount of retained earnings available and does not expect to sell any new common stock. a. Calculate the weighted average cost of capital on the basis of historical market value weights. b. Calculate the weighted average cost of capital on the basis of target market value weights. c. Compare the answers obtained in parts a and b. Explain the differences.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
After careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market value weights shown in the following table
|
Source of capital
|
Target market
value weight
|
|
Long-term debt
|
20%
|
|
|
13
|
|
Common stock equity
|
67
|
|
Total
|
100%
|
the cost of preferred stock is estimated to be 11.7%;
the cost of
and the cost of new common stock is estimated to be 17.2%.
All of these are after-tax rates. The company's debt represents 15%,
the preferred stock represents 8%,
and the common stock equity represents 77%
of total capital on the basis of the market values of the three components. The company expects to have a significant amount of retained earnings available and does not expect to sell any new common stock.
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