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.
Hook Industries’ capital structure consists solely of debt and common equity. It can issue debt at
10% interest rate, and its common stock currently pays a $2 dividend per share. The stock’s price
is currently $20; its dividend is expected to grow at a constant rate of 5 percent per year; its tax
rate is 35 percent; and its WACC is 12 percent.
1. Calculate the cost of debt and the cost of common stock.
2. What percentage of the company’s capital structure consists of debt?
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