Chapter 11, Problem 1Q

Define each of the following terms:

1. a. Weighted average cost of capital, WACC; after-tax cost of debt, r_d(1 – T); after-tax cost of short-term debt, r_std(1 – T)
2. b. Cost of preferred stock, r_ps; cost of common equity (or cost of common stock), r_s
3. c. Target capital structure
4. d. Flotation cost, F; cost of new external common equity, r_e

Summary Introduction

To discuss: Weighted average cost of capital (WACC), after-tax cost of debt r_d (1-t) and after tax cost of short term debt r_std (1-t).

Explanation of Solution

Weighted average cost of capital is nothing but minimum (expected) required rate of return and it is also called as cut of rate. It includes cost of all sources like common stock, bonds in long term and preferred stock that are weighted proportionately while calculating weighted average cost of capital.

After tax cost of debt r_d (1-t), is the applicable cost to the company for new financing of debt. For this purpose, interest that accrues on debt is allowed as deduction for tax purposes.

If a company has short-term period debt with a cost of r_std, then it’s after tax cost is r_std (1-t), is the proper cost of debt.

Summary Introduction

To discuss: Cost of preferred cost (r_ps) and cost of common equity (r_s).

Explanation of Solution

Cost of preferred stock is nothing but the cost of issuing new preferred stock by company. For perpetual preferred, it is nothing but preferred dividend divided by net issue price.

Cost of common equity is nothing but the cost of equity obtained by selling new common stocks of a company. It is basically, the cost of retained earnings income adjusted for floating costs. Floating costs are incurred when the company issues new securities for the first time.

Summary Introduction

To discuss: Target capital structure.

Explanation of Solution

The target capital structure is nothing but the relative amount of debt, common equity and preferred stock that an organization desires. Calculation of weighted average cost of capital is totally based on these target weights.

Summary Introduction

To discuss: Flotation cost and cost of new external common equity.

Explanation of Solution

The concept of floatation cost is considered when a company issues a new security. This includes fees paid to investment bankers and other legal fees. The cost of new common equity is better than that of not unusual equity raised internally by reinvesting earnings. The projects financed with external equity must earn higher returns, since the projects must cover these flotation costs.