Question

Webster Company has compiled the information shown in the following table.

Sources of capital			Book Value		Market		Cost of		Floatation Cost
					Value		Capital
Long-term debt			4,000,000.00		3,840,000.00		0.10		0%
Preferred stock			40,000.00		60,000.00		0.13		2%
Common stock equity			1,060,000.00		3,000,000.00		0.17		5%

Required:

1. Calculate the weighted-average cost of capital of the company when the company pays 40% income tax.
2. Describe the relationship between optimal capital structure and cost of capital. Don’t write more than 4 lines.
3. Should we include accounts payables in the calculation of capital structure percentages? Explain in less than six lines.

4. What is the impact of stock dividend on the cost of equity? Explain in less than 5 lines.

Answer 1

1]	After tax cost of debt = 10%*(1-40%) =	6.00%
	Cost of preferred stock = 13%+2% =	15.00%
	Cost of common stock = 17%+5% =	22.00%
2]	WACC:
	The question is silent as to whether market value weights or book value weights is to be used.
	Though market value weights are more realistic, the WACC has been worked out using
	both the BV weights and MV weights.
	Using book value weights:
	Source of Capital	Book Value	Book Value Weight	Component Cost	WACC
	Long term debt	$          4,000,000.00	78.43%	6.00%	4.71%
	Preferred stock	$                40,000.00	0.78%	15.00%	0.12%
	Common stock equity	$          1,060,000.00	20.78%	22.00%	4.57%
	Total	$          5,100,000.00			9.40%
	WACC using book value weights	9.40%
	Using market value weights:
	Source of Capital	Market Value	Market Value Weight	Component Cost	WACC
	Long term debt	$          3,840,000.00	55.65%	6.00%	3.34%
	Preferred stock	$                60,000.00	0.87%	15.00%	0.13%
	Common stock equity	$          3,000,000.00	43.48%	22.00%	9.57%
	Total	$          6,900,000.00			13.03%
	WACC using book value weights	13.03%
3]	The value of a firm, is the PV of the expected cash flows, that the firm can generate in future, when
	discounted with the cost of capital [WACC]. As the goal is to maximize the firm's value, the PV is to be
	maximized. Maximizing PV can, in turn, be done by minimizing cost of capital. To minimize cost of capital
	the proportion of debt should be ideal. It is ideal when the correct mix of debt and equity yield the
	minimum cost of capital. Thus capital structure decides the cost of capital.
4]	Capital structure includes only those sources of capital that have an explicit or implicit cost. Accounts
	payable does have neither and hence is excluded.
5]	Cost of equity, as for any other source of capital, is the discount rate that equates the expected cash flows
	resulting from the source, with its current price. In the case of equity, dividends paid by the firm are the
	expected cash flows. Dividends in turn are highly unpredictable and they are subject to many assumptions.
	Hence, dividends [their prediction] impact cost of equity.