Question

In your own words, define each of the following terms:

1. Weighted average cost of capital, WACC; after-tax cost of debt, r_d(1 - T); after-tax cost of short-term deb, r_std(1 - T)
2. Cost of preferred stock, r_ps; cost of common equity, r_s.
3. Target capital structure
4. Flotation cost, F; cost of new external common equity, r_e
5. How can the WACC be both an average cost and a marginal cost?
6. Distinguish between beta (i.e., market) risk, within-firm (i.e., corporate) risk, and stand-alone risk for a potential project. Of these three measures, which is teoretically the most relevant? Why?

Answer 1

Weighted average cost of capital:- It represent the blended cost of capital across all sources which includes common stock, preferred shares and debt. The cost of each type of capital is weighted by its percentage of total capital and then added together.

WACC= (E/V*Re) + (D/V* Rd)* (1-T)

WACC after-tax cost of debt:- after tax cost of debt used because the net cost of a company's debt is the amount of interest is paying; minus the amount it has saved in taxes as a result of its tax deductible interest payments.

Cost of Preferred stock:- is the rate of return required by the holder of the company who have preferred stock. It is calculated by dividing the annual preferred stock current market price. This is the cheapest source.

Cost of Common Equity:- is the rate of return required by the common shareholders.

Target capital structure:- it is the mix of debt, preferred stock and common stock . It is expected to optimize a company stock price. This is also known as optimal capital structure.

Flotation Cost:- This is the total cost which is incurred by a company when offering its securities to the public. This is arise because of expenses incurred in issue of new securities in market such as legal fees etc.

Cost of New external common equity:- This is the cost of newly issued common stock. This is always higher than the cost of retained earnings because of stock flotation costs.

WACC can be both an average cost and a marginal cost:- WACC is an average cost because it is a weighted average of the firm's component costs of capital. And each component cost is the marginal cost that is the cost of new capital.

BETA And Standard Deviation:- Standard deviation of return from an investment measures the total risk associated with that investment or portfolio.

While beta indicate only towards systematic risk. This is non-diversify risk and this is market specific.

Between Beta and SD, investor should prefer SD as a measure of risk because it will take both systematic and unsystematic risk while beta only consider systematic risk.