Question

Discuss the following concepts:

Debt vs. Equity financing.

The Weighted Average Cost of capital.

Why might preferred stock cost have a higher cost for a company than common stock?

Answer 1

1) Debt It is source of finance.It is amount borrowed by one party from another for operating business & repaid at later date with interest.

Equity financing It is also source of finance.Company raise fund by sale of own shares for business purpose.

2) Weighted average cost of capital  It is firm's cost of capital in which all sources of finance are proportionally weighted.As the risk of company increase, weighted average cost of capital increase.

for example - Dividend is cost of equity financing & Interest is cost of debt financing

Formula (D/V)*Kd(1-t) +(E/V)*Ke

D = Debt value

V =Total market value of firm

Kd = cost of debt

t = Tax rate

E =Equity value

Ke = cost of equity

3)Because preferred stock has regular and higher dividend .There is less risk in preferred stock than common stock.Preferred stock holder enjoy preferential rights in dividend and at the time of redemption of capital .Whereas in case of common stock ,equity holder have rights in residual income.That's why preferred stock has higher cost than common stock.