Answers and Solutions: 10 - 1 Chapter 10 The Cost of Capital ANSWERS TO END-OF-CHAPTER QUESTIONS 10-1 a. The weighted average cost of capital, WACC, is the weighted average of the after-tax component costs of capital—-debt, preferred stock, and common equity. Each weighting factor is the proportion of that type of capital in the optimal, or target, capital structure. The after-tax cost of debt, r d (1 - T), is the relevant cost to the firm of new debt financing. Since interest is deductible from taxable income, the after-tax cost of debt to the firm is less than the before-tax cost. Thus, r d (1 - T) is the appropriate component cost of debt (in the weighted average cost of capital). b. The cost of preferred stock, r ps , is the cost to the firm of issuing new preferred stock. For perpetual preferred, it is the preferred dividend, D ps , divided by the net issuing price, P n . Note that no tax adjustments are made when calculating the component cost of preferred stock because, unlike interest payments on debt, dividend payments
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