Question 33 A

A. The weighted average cost of capital is calculated using market values.

Bonds are always issued in increments of $1,000 face value. So if a company has $30,000,000 in bonds on its balance sheet, it has 30,000 bonds outstanding ($30,000,000 ÷ 1,000).

The market value of the company's bonds is 30,000 bonds × the market price of $1,083.34, or $32,500,200.

The market value of the preferred stock is $125 × 100,000 shares, or $12,500,000.

The market value of the common stock is $16 × 5,000,000 shares outstanding, or $80,000,000.

Thus, the company's total capital for the purpose of calculating its weighted average cost of capital is $32,500,200 + $12,500,000 + $80,000,000, which equals $125,000,200.

The cost of debt at market value is given as 8%. Therefore, we will use 8%, adjusted for the tax deductibility of interest, as the cost of debt.

The cost of the preferred stock is 12% of $10,000,000, or $1,200,000. At a market value of $12,500,000 (calculated above), the cost of the preferred stock is $1,200,000 ÷ $12,500,000, or .096 (9.6%).

The cost of the common stock is given as 17%.

Therefore, the calculation of the company's weighted average cost of capital, based upon the information given, is as follows:

 Long-term debt: $32,500,200 ÷ $125,000,200 × .08 × (1 - .40) = .01248 

 Preferred stock: $12,500,000 ÷ $125,000,200 × .096 =           .00959

 Common stock: $80,000,000 ÷ $125,000,200 × .17 =             .10879

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   Weighted average cost of capital                                  .13086

B. This answer results from using the market interest rate of 8% for debt without adjusting it for the tax deductibility of interest by multiplying it by (1 - the tax rate) and from using the nominal dividend rate of 12% for the preferred stock instead of a dividend rate calculated using the actual dividends paid per year divided by the market value of the preferred stock.

C. This answer results from using book values to calculate the weighted average cost of capital. Market values, not book values, should be used.

D. This answer results from using the market interest rate of 8% for debt without adjusting it for the tax deductibility of interest by multiplying it by (1 - the tax rate).