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Capital Structure and Weighted Average Cost of Capital

In computing the cost of capital, do we use the historical costs of existing debt
and equity or the current costs as determined in the market? Why?

Why is the cost of debt less than the cost of preferred stock if both securities are
priced to yield 10 percent in the market?

Why is the cost of issuing new common stock (Kn) higher than the cost of
retained earnings (Ke)?

Solution Preview

Part A:
We use current costs as determined by the market.
-cost of capital is used as a hurdle rate for selecting new projects for investment. Since, these new projects are to be financed through the new capital raised in the market either through debt or equity, current costs are relevant.
-According to principle of relevant cost, we have to take the relevant costs. Since current costs are relevant, current costs are used for calculations.
-The costs keep on changing depending on the firms risk profile.

Part B:
The interest paid on debt is a tax ...

Solution Summary

The solution explains whether we should use the current cost of capital or the historical cost of capital when we are using the cost of capital for taking decisions. Then it explains why the cost of debt is less than the cost of preferred stock. The concept is explained with an example to make it easier to understand. In the last part the cost of new equity is discussed and compared with the cost of internal equity i.e. retained earnings.