Question

Question: Given the following information, calculate the weighted average cost of capital for Hamilton Corp. Line up the calculations in the order shown in Table 11-1. Percent of capital structure:

Debt	35%
Preferred stock	20
Common equity	45

Additional information:

Bond coupon rate	11%
Bond yield to maturity	9%
Dividend, expected common	\(5
Dividend, preferred	\)12
Price, common	\(60
Price, preferred	\)106
Flotation cost, preferred	$4.50
Growth rate	6%
Corporate tax rate	35%

Short answer

Answer

The weighted average cost of capital is10.86%.

Step-by-step solution

Definition of Capital Structure

Capital structure can be defined as the proportion of the debt and equity elements present in the capital of the business entity. 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 of capital	Weightage in capital structure	Weighted cost
Debt	5.85%	35%	2.05%
Preferred stock	11.82%	20%	2.36
Common equity	14.33%	45%	6.45
Total	10.86%

Working note: Calculation of cost of capital

1. Calculation of cost of debt after tax:

$$\begin{gathered} {\mathit{K}}_{\mathbf{d}}\mathbf{=}\mathit{Y}\left(1-T\right) \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{9}\mathbf{\%}\left(1-0.35\right) \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{5}\mathbf{.}\mathbf{85}\mathbf{\%} \end{gathered}$$

2. Calculation of cost of preferred stock:

$$\begin{gathered} {\mathit{K}}_{\mathbf{P}}\mathbf{=}\frac{{\mathbf{D}}_{\mathbf{P}}}{{\mathbf{P}}_{\mathbf{p}}\mathbf{-}\mathbf{F}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathbf{\$}\mathbf{12}}{\mathbf{\$}\mathbf{106}\mathbf{-}\mathbf{\$}\mathbf{4}\mathbf{.}\mathbf{50}} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathbf{\$}\mathbf{12}}{\mathbf{\$}\mathbf{101}\mathbf{.}\mathbf{5}} \\ =11.82\% \end{gathered}$$

3. Calculation of cost of common stock:

$$\begin{gathered} {\mathit{K}}_{\mathbf{e}}\mathbf{=}\frac{\mathbf{C}\mathbf{u}\mathbf{r}\mathbf{r}\mathbf{e}\mathbf{n}\mathbf{t}\mathbf{d}\mathbf{i}\mathbf{v}\mathbf{i}\mathbf{d}\mathbf{e}\mathbf{n}\mathbf{d}}{\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{k}\mathbf{e}\mathbf{t}\mathbf{p}\mathbf{r}\mathbf{i}\mathbf{c}\mathbf{e}}\mathbf{+}\mathit{G}\mathit{r}\mathit{o}\mathit{w}\mathit{t}\mathit{h}\mathit{r}\mathit{a}\mathit{t}\mathit{e} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\frac{\mathbf{\$}\mathbf{5}}{\mathbf{\$}\mathbf{60}}\mathbf{+}\mathbf{6}\mathbf{\%} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{14}\mathbf{.}\mathbf{33}\mathbf{\%} \end{gathered}$$