Question

A company is financed with a combination of 55% equity and 45% debt. The company has a beta of 1.75. The risk free rate is 4% and the market rate of return is 16%. The debt is currently being traded in the market is 8.5%. The company tax free rate is 35%. With all these data, answer the following questions:

1. What is the company’s afteer tax cost of debt

2.what is the company’s cost of equity

3. What is the weighted average cost of capital

Answer 1

1A) After tax Cost of debt is weight of debt* cost of debt (1-Tax rate)

= 45%*8.5%(1-35%)

=3.825 (65%)

=2.48 percent

After tax cost of debt is 3.03%

2A) Total Cost of equity = Weight of equity* Cost of equity

Cost of equity as per CAPM

RF+Beta (RM-RF)

=4%+1.75 * (16%-4%)

=4% +21%=25%

Total cost of equity is 55% *25%

=13.75%

So cost of equity of the company is 13.75 percent

3) Weighted average cost of capital (WACC) formula is

Weight of debt* Cost of debt+ Weight of equity * Cost of Equity

45% *2.48+ 55% *13.75

=1.116%+7.5625%

=8.68%

So WACC of the company is 8.68 percent