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Answer (B) is correct . To maintain a capital structure of 40% debt and 60% equity, the $7 million total must consist of $2.8 million of debt and $4.2 million of equity. The equity will consist of $3?million of retained earnings and $1.2 million of new stock. The weighted-average cost of the three sources of new capital is determined as follows: Debt $2,800,000 ¡Â $7,000,000 ¡Á 10% = 4.00% Common stock $1,200,000 ¡Â $7,000,000 ¡Á 16% = 2.74% Retained earnings $3,000,000 ¡Â $7,000,000 ¡Á 14% = 6.00% ? 12.7
Answer (A) is incorrect because This figure assumes a tax adjustment for the cost of debt, but the 10% rate is an after-tax amount.
Answer (C) is incorrect because This figure assumes the equity consists solely of new common stock.
Answer (D) is incorrect because This figure is the cost of new common stock.