Global Technology's capital structure is as follows:
Preferred stock 15
Common equity 50
The after tax cost of debt is 6.5 percent; the cost of preferred stock is 10 percent; and the cost of common equity (in the form of retained earnings) is 13.5 percent. Calculate Global Technology's weighted average cost of capital in a manner similar to Table 11-1 on page 313.
From page 313
Cost of capital?Baker
Cost (aftertax) (2)
Debt Kd 7.05% 30% 2.12%
Preferred stock Kp 10.94 10 1.09
Common equity (retained earnings) Ke 12.00 60 7.20
Weighted average cost of capital Ka 10.41%
Assume that Rf = 5 percent and Km = 10.5 percent. Compute Kj for the following betas, using Formula 11A-2.
Formula 11A-2 Kj = Rf + β(Km - Rf)
Rf= Risk-free rate of return
β = Beta coefficient from Formula 11A-1
(Kj = α + βKm + e)
Km= Return on the market index
Km - Rf = Premium or excess return of the market versus the risk-free rate (since the market is riskier than Rf, the assumption is that the expected Km will be greater than Rf)
β(Km -Rf)= Expected return above the risk-free rate for the stock of Company j, given the level of risk
This solution shows step-by-step calculations to determine the Weighted Average Cost of Capital and the expected return above the risk-free rate. All formulas are workings are shown in a clear manner with brief explanations.