Question

Bounds on the Weighted Average Cost of Capital. The firm is financed by 30% of debt and 70% of equity. The corporate tax rate is 35%. The firm pays 2% interest rate on its debt to investors. The risk-free rate in the economy is also 2% and the firm equity has beta of 2.5.

a) What is the lower bound for the firm’s weighted average cost of capital?

b) What is the upper bound for the firm’s weighted average cost of capital?

Answer #1

WACC = D*K_{d}*(1-t)/(D+E) + E*K_{e}/(D+E)

where D is the amount of debt in the capital structure,

E is the amount of equity in the capital structure

K_{d} is the cost of debt

Ke is the cost of equity

t is the corporate tax rate

Here, we have D/(D+E) as 30%,

E/(D+E) as 70%

K_{d} as 2%

t as 35%

We need to find the cost of equity (K_{e})

According to CAPM,

k_{e} = r_{f} + B(r_{m} -
r_{f})

= 2% + 2.5 (r_{m} - 2%)

= 2% + 2.5r_{m} - 5%

= 2.5r_{m} - 3%

WACC = 30% * 2% * (1 - 35%) + 70% * K_{e}

= 0.39% + 70% * (2.5r_{m} - 3%)

= 0.39% - 2.1% + 1.75r_{m}

= -1.71% + 1.75r_{m}

Plug in the range of r_{m} as provided in the question
(not mentioned here), or google it as per the name of the firm to
find the range of WACC.

As manager of ACME industries, your company is 30% debt
financed, 70% equity financed. Assuming the debt is risk-free, and
assuming that your equity beta is 1.1, that treasury bills yield
1%, and that the market has an expected return of 8%, what is your
weighted average cost of capital assuming a 35% tax rate? Should
you invest in a new project with a 10% IRR?

The weighted average cost of capital for a firm:
A. remains constant when the firm’s capital structure
changes.
B. is unaffected when there is any change in the corporate tax
rate.
C. is equivalent to the after-tax cost of the firm’s outstanding
debt.
D. is a weighted average between the cost of equity and the
(after-tax) cost of debt.

Chapters 7, 9
& 10 Exam
2.
The weighted average cost of capital
A)
typically involves a proportionate weighting of the return on
equity and the return on debt.
B)
reflects a discount rate that implies the use of all debt for
financing.
C)
is used to value the equity of the firm.
D)
never changes once it is determined.
Chapter 9
Problems:
1.
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sixty percent with equity. Umpqua’s
expected...

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on short-term debt is 5%, and the marginal tax rate is 35%.
The market risk premium is 5%, the risk-free rate is 3%, and the
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The firm’s capital structure is as follows:...

Suppose the WACC (weighted average cost of capital) of a firm is
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corresponding unlevered firm is 15 percent. By assuming that the
Modigliani-Miller Theorem with corporate taxes holds, answer the
following questions.
i) What is the effective corporate tax rate for the firm?
ii) What is the cost of equity of the firm?

Calculate the weighted average cost of capital for a firm with
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on new debt is 2%, the yield on the preferred is 6%, the cost of
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6. 62%
6.45%
7.33%
8.18%
9.00%

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...

. Firm Green’s capital structure is 30% debt and 70% equity and
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interest rate is 3%, and the expected return on the market
portfolio equals 8%.
(c) Discuss the impact of corporate taxes on the optimal capital
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You are asked to calculate the weighted average cost of capital
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zero coupon bond maturing in ten years. The $1000 par value bond
currently trades at $558.40 in the market. The tax rate is 35% and
Meritel capital structure is 50% debt...

Explain why the weighted average cost of capital is invariant to
the firm’s debt-equity ratio in the absence of corporate taxes.

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