Question

The Two Dollar Store has a cost of equity of 12.1 percent, the YTM on the company's bonds is 5.9 percent, and the tax rate is 39 percent. If the company's debt–equity ratio is .56, what is the weighted average cost of capital?

Select one:

8.58%

6.65%

9.05%

9.65%

7.87%

Answer 1

First of all lets find after tax cost of debt

After tax cost of debt = YTM(1-tax rate)

=5.9%(1-39%)

=5.9%(1-0.39)

=5.9%(0.61)

=3.6%

Debt to equity ratio = 0.56

Thus Debt/equity = 0.56

Debt/1 = 0.56

Thus Equity = 1 and debt = 0.56

Thus Weight of debt in capital structure = 0.56/(1+0.56)

=0.56/1.56 = 35.90%

Thus weight of equity in capital structure = 1-0.3590

=0.6410

i.e. 64.10%

Statement showing WACC

Particulars	Weight	Cost of capital	WACC
a	b	c =axb
Equity	64.10%	12.10%	7.76%
Debt	35.90%	3.60%	1.29%
WACC			9.05%

Thus WACC = 9.05%