Answer (C) is correct . The first step is to determine the component costs of each form of capital. Multiplying the current yield of 9% (since the coupon rate is not given) times one minus the tax rate (1.0 – .40 = .60) results in an after-tax cost of debt of 5.4% (9% × .60). Since the preferred stock is trading at par, the component cost is 6% (the annual dividend rate). The component cost of common equity is calculated using the dividend growth model, which combines the dividend yield with the growth rate. Dividing the $1.20 ? dividend by the $40 market price produces a dividend yield of 3%. Adding the 3% dividend yield and the 10% growth rate gives a 13% component cost of common equity. Once the costs of the three types of capital have been computed, the next step is to weight them according to their current market values. The market value of the long-term debt is 80% of its carrying amount, or $5,600,000 ($7,000,000 × 80%). The $1,000,000 of preferred stock is selling at par. The common stock has a current market value of $8,000,000 (200,000 shares × $40). Long-term debt $??5,600,000 × 5.4% = $???302,400 Preferred stock 1,000,000 × 6.0% = 60,000 Common stock 8,000,000 × 13.0% = 1,040,000 Totals $14,600,000 $1,402,400 Thus, the weighted-average cost of capital is 9.6% ($1,402,000 ÷ $14,600,000).
Answer (A) is incorrect because This percentage is the cost of equity.
Answer (B) is incorrect because This percentage is the simple average.
Answer (D) is incorrect because This percentage is based on carrying amounts.
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The firm’s bonds are currently selling at 80% of par, generating a current market yield of 9%, and the corporation has a 40% tax rate. The preferred stock is selling at its par value and pays a 6% dividend. The common stock has a current market value of $40 and is expected to pay a $1.20 per share dividend this fiscal year. Dividend growth is expected to be 10% per year, and flotation costs are negligible. The firm’s weighted-average cost of capital is (round calculations to tenths of a percent)