Question

Question: Given the following information, calculate the weighted average cost of capital for Digital Processing Inc. Line up the calculations in the order shown in Table 11-1.

Percent of capital structure:

Preferred stock	20%
Common equity	40
Debt	40

Additional information:

Corporate tax rate	34%
Dividend, preferred	\(8.50
Dividend, expected common	\)2.50
Price, preferred	\(105
Growth rate	7%
Bond yield	9.5
Flotation cost, preferred	\)3.60
Price, common	$75

Short answer

The weighted average cost of capital is 8.32%.

Step-by-step solution

Definition of Capital Structure

Capital structure refers to a structure that shows the distribution of the capital of the business entity in the form of debt and equity. The business entity uses the debt-to-equity ratio to determine the risk associated with capital borrowings

Calculation of weighted average cost of capital

Particular	Cost	Weightage	The weighted average cost of capital
Debt	6.27%	40%	2.51%
Preferred stock	8.38%	20%	1.68%
Common equity	10.33%	40%	4.13%
Total	8.32

Working note:

Calculation of cost of debt:

$\begin{array}{rcl}{\mathit{K}}_{\mathbf{d}}& \mathbf{=}& \mathit{Y}\mathbf{(}\mathbf{1}\mathbf{-}\mathbf{T}\mathbf{)}\\ & \mathbf{=}& \mathbf{9}\mathbf{.}\mathbf{5}\mathbf{\%}\mathbf{(}\mathbf{1}\mathbf{-}\mathbf{0}\mathbf{.}\mathbf{34}\mathbf{)}\\ & \mathbf{=}& \mathbf{6}\mathbf{.}\mathbf{27}\mathbf{\%}\\ & & \end{array}$

Calculation of cost of preferred stock:

$\begin{array}{rcl}{\mathit{K}}_{\mathbf{P}}& \mathbf{=}& \frac{{\mathbf{D}}_{\mathbf{p}}}{{\mathbf{P}}_{\mathbf{P}}\mathbf{-}\mathbf{F}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{8}\mathbf{.}\mathbf{50}}{\mathbf{\$}\mathbf{105}\mathbf{-}\mathbf{\$}\mathbf{3}\mathbf{.}\mathbf{60}}\\ & \mathbf{=}& \mathbf{8}\mathbf{.}\mathbf{38}\mathbf{\%}\\ & & \end{array}$

Calculation of cost of common equity:

$\begin{array}{rcl}{\mathit{K}}_{\mathbf{e}}& \mathbf{=}& \frac{{\mathbf{D}}_{\mathbf{1}}}{{\mathbf{P}}_{\mathbf{0}}}\mathbf{+}\mathit{g}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{2}\mathbf{.}\mathbf{50}}{\mathbf{\$}\mathbf{75}}\mathbf{+}\mathbf{7}\mathbf{\%}\\ & \mathbf{=}& \mathbf{10}\mathbf{.}\mathbf{33}\mathbf{\%}\\ & & \end{array}$