Answer (C) is correct . The cost for equity capital is given as 15%, and preferred stock is 10%. The before-tax rate for debt is given as 6%, which translates to an after-tax cost of ? 3.9% [6% × (1.0 – .35)]. The rates are weighted as follows: Component Weighted Component Weight Cost Cost Long-term debt 25% × 3.9% = .975% Preferred stock 10% × 10.0% = 1.000% Common stock 65% × 15.0% = 9.750% 11.725%
Answer (A) is incorrect because This percentage is an unweighted average of the three costs, and also ignores the tax shield.
Answer (B) is incorrect because Using the complement of the tax rate instead of the tax rate to calculate the tax shield results in 11.275%.
Answer (D) is incorrect because This percentage ignores the tax savings on debt capital.
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