Unit 8 - Corporate Capital Structure

Question 1

The degree of FINANCIAL LEVERAGE equation is

Answer 1

% Change in Earnings per Shared / Divided by % Change in EBIT

EBIT = Earnings before income taxes

Question 2

Equation for “ Actual Cost of Debt”

Answer 2

Interest rate X (1 - marginal tax rate)

When using bonds, use the “EFFECTIVE INTEREST RATE” not the coupon rate.

Question 3

Component cost of Preferred stock

Answer 3

Dividend / Market price

Equation above is also known as “Dividend Yield”

Question 4

Weighted-average cost of capital formula (WACC) is for the different components:

Debt

Preferred stock

Common Stock /Retained Earnings

Answer 4

Calculate cost component for debt

= Effective Rate X ( 1 - Marginal Tax rate)

Calculate cost component for Preferred Stock (PS)

= Cash dividends / Market Price

(Cash dividends = carrying amount of PS X Rate of PS)
** Note that Carrying amount is used to calculate Cash dividends, NOT market value

For CS and RE - Component cost is usually given and tends to be equal, so no need to calculate

1st Step is to calculate proportions based on Market Values

Then.. Proportions X Component Cost = Weighted Cost

Add all the weighted cost for each and total is WAAC