Question

The capital structure for the XYZ Company measured using the market values of each of the firm’s sources of capital provided below. The company plans to maintain its debt structure in the future. If the firm has a 18% after tax cost of debt, 10% cost of preferred stock, and an 27% cost of company equity, what is the firm’s average cost of capital?

Capital structure in Market Values ($000)

Bonds​​​$500,000

Preferred stock​​ 100,000

Common stock​​ 400,000

Answer 1

Solution :-

Total Capital Value = $500,000,000 + $100,000,000 + $400,000,000 = $1,000,000,000

Weight of Bond ( Wd ) = ( $500,000,000 / $1,000,000,000 ) = 0.50

Weight of Preferred Stock ( Wp ) = ( $100,000,000 / $1,000,000,000 ) = 0.10

Weight of Common Stock ( We ) = ( $400,000,000 / $1,000,000,000 ) = 0.40

After tax Cost of Debt ( kd ) = 18%

Cost of Preferred Stock ( Kp ) = 10%

Cost of Equity ( Ke ) = 27%

Now Firm’s average cost of capital = ( Wd * kd ) + ( Wp * Kp ) + ( We * ke )

= ( 0.50 * 18% ) + ( 0.10 * 10% ) + ( 0.40 * 27% )

= 9% + 1% + 10.8%

= 20.8%

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