Question
The calculation of a firms weighted, or overall, cost of capital involves calculating the weighted average of the required rates of return on the companys
The calculation of a firms weighted, or overall, cost of capital involves calculating the weighted average of the required rates of return on the companys debt and preferred and common equity, where the weights equal the percentage of each type of financing in the firms overall capital structure. The general formula for the computation of a firms weighted cost of capital is: ka = [(E(E+B+Pf)) x ke] + [(B(E+B+Pf)) x kdx (1 - T)] + [(Pf(E+B+Pf)) x kp] where, ka = the firms weighted marginal cost of capital E = the dollar amount of in the firms target capital structure = the after-tax cost of the firms internal common equity (retained earnings) B = the dollar amount of in the firms target capital structure kd = the cost of the firms debt capital T = the firms tax rate Pf = the dollar amount of in the companys target capital structure kp = cost of the firms preferred stock capital Smith Company has a target capital structure that consists of $4.9 million of debt capital, $2.5 million of preferred stock financing, and $4.3 million of common equity. The corresponding weights of its debt, preferred stock, and common equity financing that should be used to compute its weighted cost of capital (rounded to the nearest wo decimal places) are: 37.69%, 24.58%, and 37.73%, respectively 36.75%, 41.88%, and 21.37%, respectively 41.88%, 21.37%, and 36.75%, respectively 37.73%, 37.69%, and 24.58%, respectively Consider the following case: Burton Limited, a key competitor of Smith Company in the computer technology field, has a capital structure consisting of 35% debt, 10% preferred stock, and 55% common equity. Concerned that its cost of capital may put it at a competitive disadvantage vis-a-vis the Smith Company, a Burton analyst has been tasked with computing and comparing the weighted costs of capital of both companies. As the Burton analyst, and through your dogged research, youve collected the following capital structure and component cost data for both companies. (Remember, you dont have access to confidential financial information for Smith Company, so youve had to rely on balance sheet data collected from their published financial statements.) Complete the following table by computing each companys weighted cost of capital (rounded to four decimal places) and answer the related question that follows: Financial Data Burton Limited Data Smith Company Data Debt Weight (wd) 35% 30% Cost (kd) 5.50% 6.00% Preferred stock Weight (wp) 10% 5% Cost (kp) 7.00% 8.15% Common equity Weight (we) 55% 65% Cost (ke) 8.75% 11.75% Tax rate (T) 40% 35% Weighted cost of capital (ka) If a firms weighted cost of capital represents the overall or summary indicator of the markets perception of a firms riskiness (across its different sources of financing), then which company currently appears to exhibit the greater risk? Burton Limited Smith Company
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