A. This answer results from using the book values of the components of capital instead of their market values in calculating the weights for each component of the capital.

B. In order to calculate the WACC we need to determine the cost and fair value of each of the components of the financing. In this question, these are 1) debt, 2) preferred shares, and 3) common shares. The debt has a fair value of $5,600 (because it is selling at 80% of the book value) and the interest cost is 9%. However, because the interest on the debt is tax-deductible, the after-tax cost is .09 × (1 - .40), which is .054 or 5.4%.

The preferred shares have a market value of $1,000 and a cost of 6%. There is no effect of taxes on the preferred dividends. The common stock has a market value of $8,000 (200 shares outstanding × $40 per share). The cost of the common stock is determined using the Gordon Growth (or Dividend Growth) model, and we get a cost of 13% ((1.20 ÷ 40) + .10 = .13 or 13%). The total market value of the capital is $5,600 + $1,000 + $8,000 = $14,600. Debt is 38% of the total ($5,600 ÷ $14,600); preferred stock is 7% of the total ($1,000 ÷ $14,600); and equity is 55% of the total ($8,000 ÷ $14,600). The weighted average cost of capital is the sum of the weight for each component multiplied by its cost, which is:(.38 × .054) +  (.07 × .06) + (.55 × .13) = .0962 or 9.6%.

C. This answer used the face value of the debt instead of the market value of the debt and the before-tax cost of the debt instead of the after-tax cost of the debt in the calculation of the cost of capital. See the correct answer for a complete explanation.

D. This answer did not include the effect of taxes in the calculation of the cost of debt. See the correct answer for a complete explanation.