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.