The cost of preferred stock is 6 percent, and the cost of debt is 8 percent. The relevant tax rate is 35 percent. The company president has approached you about its capital structure. He wants to know why the company doesn’t use more preferred stock financing because it costs less than debt. What would you tell the president?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
The cost of
percent. The relevant tax rate is 35 percent. The company president
has approached you about its capital structure. He wants to know why
the company doesn’t use more preferred stock financing because it
costs less than debt. What would you tell the president?
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