1. Why do firms have different capital structures and how does capital structure
ID: 2788754 • Letter: 1
Question
1. Why do firms have different capital structures and how does capital structure influence a firm’s weighted average cost of capital?
2. What are the basic sources of financing included in a firm’s capital structure? Specifically, what financing sources are excluded from the firm’s capital structure when calculating firm WACC?
3. (Weighted average cost of capital) The target capital structure for JT Industries is 40 percent common stock, 10 percent preferred stock, and 50 percent debt. If the cost of common equity for the firm is 18 percent, the cost of preferred stock is 10 percent, the before-tax cost of debt is 8 percent, and the firm’s tax rate is 35 percent, what is JT’s weighted average cost of capital?
Explanation / Answer
Answer 1) Each firm has different Capital Structure because each firm is distinct .Financial Executive try to create the optimal capital Structure by diversifying company debts and the outstanding shares.Optimum Capital Structure is important to decrease expenses and increasing profits for the shareholders,hence keeping this in mind the capital structure is designed and may vary from firm to firm due to distinct nature of business,circumstances in which they operate.
An Optimum Capital Structure tends to decrease the weighted average cost of Capital.
Answer 2) Basics Sources of Financing included in a Firms Capital Structure :-
Debt (Borrowed Funds Like Term Loans,Debentures)
and Equity(Shareholders Funds)
The Non-Interest bearing Debt should be excluded from the firm's capital structure when calculating firm WACC.
Answer 3)
WACC= (E/V) x RE + (P/V) x RP + (D/V) x RD x (1 - TC)
Weighted Average Cost of capital = Weight of debt component [D/V] * After tax cost of debt [RD x (1 - TC)]+ Weight of preferred stock component (P/V)* Cost of preferred stock RP ] + Weight of common stock(E/V) x Cost of common stock RE
what is JT's weighted average cost of capital= 0.50* 8%*(1-.35) + 0.10* 10%+ 0.40* 18%
=10.80%
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