Question

Wisdom Institute of Education is a reputed public company and wishes to estimate its cost of capital. The company’s current capital structure, in terms of market value, includes 30% debt, 20% preferred equity, and 50% ordinary shares. The company’s debt has an average yield to maturity of 8.3%. Its preferred shares have a $70 par value, an 8% dividend, and are currently selling for $76 per share. Wisdom beta is 1.5, the risk-free rate is 4.5%, and the market rate is 11.4%. The company is in the 30% tax bracket.

a)       Calculate the after-tax costs of debt and ordinary shares of the company.

b)      Calculate Wisdom’s weighted average cost of capital (WACC) on both a pre-tax and after-tax basis.

c)       Which WACC should Wisdom use when making investment decisions? Justify your answer

Answer 1

a) after Tax costs of debt =8.3%*(1-30%) =5.81%
Cost of Equity =Risk Free Rate+Beta*(Market Return-Risk Free Rate) =4.5%+1.5*(11.4%-4.5%) =14.85%
Cost of Preferred Stock =8%*70/76=7.3684%

b) WACC of Pretax basis =Weight of Equity*Cost of Equity + Weight of Preferred Stock*Cost of Preferred Stock)+Weight of Debt*Cost of Debt =50%*14.85%+20%*7.3684%+30%*8.3% =11.39%

WACC after Pretax basis =Weight of Equity*Cost of Equity + Weight of Preferred Stock*Cost of Preferred Stock)+Weight of Debt*Cost of Debt*(1-Tax Rate) =50%*14.85%+20%*7.3684%+30%*5.81% =10.64%

c) Wisdom should use after tax basis WACC . This is because interest payments on debt are tax deductible.