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**Unformatted text preview: **ll be financed
using retained earnings, kr , or new common stock, kn.
EXAMPLE In earlier examples, we found the costs of the various types of capital for Duchess
Corporation to be as follows:
Cost of debt, ki
Cost of preferred stock, kp
Cost of retained earnings, kr
Cost of new common stock, kn 5.6%
10.6%
13.0%
14.0% CHAPTER 11 Hint For computational
convenience, the financing
proportion weights are listed in
decimal form in column 1 and
the specific costs are shown in
percentage terms in column 2. TABLE 11.1 The Cost of Capital 483 Calculation of the Weighted
Average Cost of Capital for
Duchess Corporation
Cost
(2) Weighted cost
[(1) (2)]
(3) 5.6% 2.2% Source of capital Weight
(1) Long-term debt 0.40 Preferred stock 0.10 10.6 Common stock equity 0.50 13.0 Totals 1.00 1.1
6.5
9.8% Weighted average cost of capital 9.8% The company uses the following weights in calculating its weighted average cost
of capital:
Source of capital Weight Long-term debt 40% Preferred stock 10 Common stock equity
Total 50
100% Because the firm expects to have a sizable amount of retained earnings available ($300,000), it plans to use its cost of retained earnings, kr , as the cost of
common stock equity. Duchess Corporation’s weighted average cost of capital is
calculated in Table 11.1. The resulting weighted average cost of capital for
Duchess is 9.8%. Assuming an unchanged risk level, the firm should accept all
projects that will earn a return greater than 9.8%. Weighting Schemes
Weights can be calculated on the basis of either book value or market value and
using either historical or target proportions.
book value weights
Weights that use accounting
values to measure the proportion
of each type of capital in the
firm’s financial structure.
market value weights
Weights that use market values
to measure the proportion of
each type of capital in the firm’s
financial structure. Book Value Versus Market Value
Book value weights use accounting values to measure the proportion of each type
of capital in the firm’s financial structure. Market value weights measure the proportion of each type of capital at its market value. Market value weights are
appealing, because the market values of securities closely approximate the actual
dollars to be received from their sale. Moreover, because the costs of the various
types of capital are calculated by using prevailing market prices, it seems reasonable to use market value weights. In addition, the long-term investment cash 484 PART 4 Long-Term Financial Decisions flows to which the cost of capital is applied are estimated in terms of current as
well as future market values. Market value weights are clearly preferred over
book value weights. Historical Versus Target
historical weights
Either book or market value
weights based on actual capital
structure proportions. target weights
Either book or market value
weights based on desired capital
structure proportions. Historical weights can be either book or market value weights based on actual
capital structure proportions. For example, past or current book value proportions would constitute a form of historical weighting, as would past or current
market value proportions. Such a weighting scheme would therefore be based on
real—rather than desired—proportions.
Target weights, which can also be based on either book or market values,
reflect the firm’s desired capital structure proportions. Firms using target weights
establish such proportions on the basis of the “optimal” capital structure they
wish to achieve. (The development of these proportions and the optimal structure
are discussed in detail in Chapter 12.)
When one considers the somewhat approximate nature of the calculation of
weighted average cost of capital, the choice of weights may not be critical. However,
from a strictly theoretical point of view, the preferred weighting scheme is target
market value proportions, and these are assumed throughout this chapter. Review Questions
11–11 What is the weighted average cost of capital (WACC), and how is it
calculated?
11–12 Describe the logic underlying the use of target capital structure weights, and
compare and contrast this approach with the use of historical weights. What
is the preferred weighting scheme? LG5 LG6 11.6 The Marginal Cost and Investment Decisions
The firm’s weighted average cost of capital is a key input to the investment
decision-making process. As demonstrated earlier in the chapter, the firm
should make only those investments for which the expected return is greater
than the weighted average cost of capital. Of course, at any given time, the
firm’s financing costs and investment returns will be affected by the volume of
financing and investment undertaken. The weighted marginal cost of capital
and the investment opportunities schedule are mechanisms whereby financing
and investment decisions can be made simultaneously. The Weighted Marginal Cost of Capital (WMCC)
The weighted average cost of capital may vary over time, dependi...

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