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WACC and target weightsAfter careful analysis, Dexter Brothers has determined that its optimal capital structure is composed of the sources and target market value weights shown in the following table:

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.The cost of debt is estimated to be

6.8%;

the cost of preferred stock is estimated to be

14.6%;

the cost of retained earnings is estimated to be

17.1%;

and the cost of new common stock is estimated to be

19.1%.

All of these are after-tax rates. The company's debt represents

19%,

the preferred stock represents

5%,

and the common stock equity represents

76%

of total capital on the basis of the market values of the three components. The company expects to have a significant amount of retained earnings available and does not expect to sell any new common stock.a. Calculate the weighted average cost of capital on the basis of historical market value

weights.

b.Calculate the weighted average cost of capital on the basis of target market value

weights.

c.Compare the answers obtained in parts a and b.Explain the differences.

Question content area bottom

Part 1

a. The weighted average cost of capital on the basis of historical market value weights is

enter your response here%.

(Round to two decimal places.)

Part 2

b.The weighted average cost of capital on the basis of target market value weights is

enter your response here%.

(Round to two decimal places.)

Part 3

c.Compare the answers obtained in parts a and b. Explain the differences. (Select the best answer below.)

A.

Using historical weights, the firm has a lower cost of capital because historical costs are often lower than future expected costs.

B.

Using historical weights, the firm has a higher cost of capital because historical costs are often higher than future expected costs.

C.Using historical weights, the firm has a higher cost of capital due to the weighting of the more expensive common stock component,

76%,

versus the target weight of

66%.

D.Using historical weights, the firm has a lower cost of capital due to the weighting of the more expensive common stock component,

76%,

versus the target weight of

66%.

Long-term debt 24% Preferred stock 10% Common stock equity 66% Total 100%

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