P9–15 WACC and target weights After careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market value weights shown in the following table.

The cost of debt is estimated to be 7.2%, the cost of preferred stock is estimated to be 13.5%, the cost of retained earnings is estimated to be 16.0%, and the cost of new common stock is estimated to be 18.0%. All are after-tax rates. The company’s debt represents 25%, the preferred stock represents 10%, and the common stock equity represents 65% of total capital on the basis of the market values of the three components. The company expects to have a significant amount of retained earnings available and does not expect to sell any new common stock.

a. Calculate the weighted average cost of capital on the basis of historical market value weights.

b. Calculate the weighted average cost of capital on the basis of target market value weights.

c. Compare the answers obtained in parts a and

b. Explain the differences.

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Source of capital Long-term debt Preferred stock Common stock equity Total Target market value weight 30% 15 55 100%