Question

You are the finance manager for delta enterprise. You are calculating the cost of capital for your company. You want to maintain a capital structure of 25% debt, 25% preferred stock, and 50% common stock. The cost of financing with retained earnings is 12%, the cost of preferred stock financing is 8.5%, and the before-tax cost of debt financing is 8%, Calculate the weighted average cost of capital (WACC) given the tax rate is 45%. What will be the effect on WACC, if the tax rate decrease?

Please solve the question using an excel sheet

Answer 1

WACC = We * Ke + Wp * Kp + Wd * Kd * (1-T)

where

We - Weight of the firm’s equity = 50%

Wd - Weight of the firm’s debt = 25%

Wp - Weight of the firm’s preferred stock = 25%

Re - cost of equity = 12%

Rd - cost of debt = 8%

Rp - cost of preferred stock = 8.5%

T - Tax rate = 45%

WACC = .5*12 + .25*8.5 + .25*8*(1-.45)

= 6+2.125+1.1

= 9.225%

As the tax rate decreases, cost of debt increases as we are losing tax savings on debt interest. Hence WACC also increases.