Which of the following is true regarding the weighted-average cost of capital?
A) The book value of the components of capital should always be used to calculate the weighted-average cost of capital.
B) A company may have two weighted-average costs of capital if the firm's capital structure is so large that new common stock must be sold.
C) The cost of common equity is lower than the cost of retained earnings.
D) The cost of preferred stock is adjusted for the tax deduction associated with preferred dividends.

Question

Quizplus · Accepted Answer

A company may have two weighted-average costs of capital if the firm's capital structure is so large that new common stock must be sold. This is known as a two-tiered system, where the first tier includes debt and preferred stock and the second tier includes common stock. The cost of capital is higher for the second tier since it is riskier than the first tier. The weighted-average cost of capital is calculated by taking the average of the costs of capital for each tier, weighted by the proportion of each tier in the company's capital structure. Option A is incorrect because the market value of the components of capital should be used to calculate the weighted-average cost of capital, not the book value. Option C is incorrect because the cost of common equity is typically higher than the cost of retained earnings since issuing new stock incurs flotation costs. Option D is incorrect because there is no tax deduction associated with preferred dividends, so the cost of preferred stock is not adjusted for taxes.

Which of the Following Is True Regarding the Weighted-Average Cost