Question

Armadillo Mfg. Co. has a target capital structure of 50% debt and 50% equity. They are...

Armadillo Mfg. Co. has a target capital structure of 50% debt and 50% equity. They are planning to invest in a project which will necessitate raising new capital. New debt will be issued at a before-tax yield of 12%, with a coupon rate of 10%. The equity will be provided by internally generated funds. No new outside equity will be issued. If the required rate of return on the firm's stock is 15% and its marginal tax rate is 40%, compute the firm's cost of capital.

1.

11.1%
2.

7.2%
3.

13.5%
4.

12.5%
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Answer #1

Given data:

  • Cost of Debt = 12% {Cost of Debt is the Yeild to Maturity of the bond (which is 12%) and not its coupon rate}
  • Weight of Debt = 50%
  • Cost of Equity = 15%
  • Weight of Equity = 50%
  • Marginal Tax rate = 40%

Formula for WACC is:

WACC = [15% * 50%] + [12% * 50% * (1 - 40%)]
= [15% * 50%] + [12% * 50% * 60%]
= 7.5% + 3.6%
= 11.1%

Hence, WACC = 11.1%

The correct answer is Option 1 (11.1%).

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