***Must answer each question and each portion to each question. Show work. 1. Wh

ID: 2805648 • Letter: #

Question

***Must answer each question and each portion to each question. Show work.

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

SOURCE

WEIGHT

COST

WEIGHT*COST

COMMON STOCK

0.4

7.2

PREFERRD STOCK

0.1

DEBT

0.5

5.2

2.6

WEIGHTED AVERAGE COST OF CAPITAL

10.8

AFTER TAX COST OF DEBT

BEFORE TAX COST*(1-TAX RATE)

8*(1-.35)

5.20%

SOURCES OF FINANCING INCLUDED INTO CAPITAL STRUCTURE ARE (1)LONG TERM DEBT (2) ISSUANCE OF COMMON STOCK (3) ISSUANCE OF PREFERRED STOCK AND RETAINED EARNINGS. But short term sources of financing like accounts payable, short term debts are not included in calculation of weighted average cost of capital.

Firm have different capital structure because of the requirement of funds and availability of funds with the cost involved. Choice of source of financing and the proportion of fund in total fund requirement affects the weighted average cost of capital