Question

The Manx Company was recently formed to manufacture a new product. It has the following capital structure in market value terms:

Debt $6,000,000

Preferred Stock $2,000,000

Common Stock $8,000,000

Total $16,000,000

The company has a marginal tax rate of 40 %. The required return on equity (using CAPM) in this line of business is 17 percent. The Manx’s debt is currently yielding 13 percent, and its preferred stock is yielding 12 percent. Compute the firm’s Weighted Average Cost of capital.?

Answer 1

Given cost of debt =13%

Post tax cost of debt =13%*(1-tax rate)

=13%*(1-40%)

=7.8%

Weighted average cost of capital is calculated as

= weight of debt in capital * post tax cost of debt+ weight of preferred stock *cost of preferred stock+ weight of equity * cost of equity

= 6000000/16000000*7.8%+2000000/16000000*12%+8000000/16000000*17%

=0.375*7.8%+0.125*12%+0.50*17%

=2.925%+1.5%+8.5%

=12.925%

(note: it is assumed that cost of debt given is pre tax.

Also preferred stock gets dividend which are not tax deductible hence are not adjusted for tax)