Question

A firm’s capital structure is 10% debt and 90% common equity. The tax rate is 25%, the interest rate on new debt is 12%, and the cost of common equity is 16.15%. The firm’s weighted average cost of capital (WACC) is what %. This is calculated to two decimal places using the following formula: WACC = WCS × CCS + WPS × CPS + WD × CD

Answer 1

WACC = WCS × CCS + WPS × CPS + WD × CD

or WACC =Cost of Equity * Weight of Equity in Capital Structure + Cost of Debt(1-t) * Weight of Debt in Capital Structure + Cost of Preferred Stock * Weight of Preferred Stock in Capital Structure

W_CS = Weight of Equity in Capital Structure = 90% & C_CS = Cost of Equity = 16.15%

W_D = Weight of Debt in Capital Structure = 10% & C_D = Cost of Debt = 12%

WACC = 16.15% * 90% + 12% * 10% (There is no preference share component in Capital Structure, i.e. WPS =0)

But the Cost of Debt (C_D) need to be adjusted for tax as Interest on borrowings is tax deductible.

WACC = 16.15% * 90% + 12% (1 - 25%) * 10%

WACC = 14.535% + 0.9% = 15.435% = 15.44%