Principles of Managerial Finance

CHAPTER 11 The Cost of Capital 483

The company uses the following weights in calculating its weighted average cost

of capital:

Because the firm expects to have a sizable amount of retained earnings avail-

able ($300,000), it plans to use its cost of retained earnings, kr, as the cost of

common stock equity. Duchess Corporation’s weighted average cost of capital is

calculated in Table 11.1. The resulting weighted average cost of capital for

Duchess is 9.8%. Assuming an unchanged risk level, the firm should accept all

projects that will earn a return greater than 9.8%.

Weighting Schemes

Weights can be calculated on the basis of either book valueor market valueand

using either historicalor targetproportions.

Book Value Versus Market Value

Book value weightsuse accounting values to measure the proportion of each type

of capital in the firm’s financial structure. Market value weightsmeasure the pro-

portion of each type of capital at its market value. Market value weights are

appealing, because the market values of securities closely approximate the actual

dollars to be received from their sale. Moreover, because the costs of the various

types of capital are calculated by using prevailing market prices, it seems reason-

able to use market value weights. In addition, the long-term investment cash

Source of capital Weight

Long-term debt 40%

Preferred stock 10

Common stock equity  (^5)  (^0) 
Total 1

0

0

%
market value weights
Weights that use market values
to measure the proportion of
each type of capital in the firm’s
financial structure.
book value weights
Weights that use accounting
values to measure the proportion
of each type of capital in the
firm’s financial structure.
TABLE 11.1 Calculation of the Weighted
Average Cost of Capital for
Duchess Corporation
Weighted cost
Weight Cost [(1)(2)]
Source of capital (1) (2) (3)
Long-term debt 0.40 5.6% 2.2%
Preferred stock 0.10 10.6 1.1
Common stock equity  0 . (^5)  (^0)  13.0 (^6) . (^5) 
Totals 1.00 9

.

8

%
Weighted average cost of capital9.8%
Hint For computational
convenience, the financing
proportion weights are listed in
decimal form in column 1 and
the specific costs are shown in
percentage terms in column 2.