Question

For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. (rs=return on equity, cost of equity; rd=return on debt, cost of debt; WACC=weighted avg. cost of capital)
A) rs > rd > WACC.

B) rs > WACC > rd.

C) WACC > rs > rd.

D) rd > rs > WACC.

Answer 1

Answer:

B) rs > WACC > rd.

Explanation:

The formula to compute WACC is shown below:

= Weightage of debt × cost of debt × ( 1- tax rate) + (Weightage of preferred stock) × (cost of preferred stock) + (Weightage of  common stock) × (cost of common stock)

As we know that the risk of equity in comparison to debt is more. And the return in respect of equity is received as an interest whereas for the debt it is received as a dividend.  

And, The WACC has come between debt and equity