Question

A us based company has a market value of its debt equal to $40 million and has 3 million outstanding shares of stock , each selling for $20 per share. The company pays a 5% rate of interest on its debt and has a beta of 1.41. The corporate tax rate is 34%. The risk premium on the market is 9.5%. the current treasury bill rate is 1%. What is the firm’s weighted average cost of capital?

Answer 1

Ans : Weighted Average Cost of Capital

WACC = (Cost of Equity * Equity Proportion) + (Cost of Debt after tax * Debt Proportion)

1) Debt/Equity Proportion

Total Capital = Total Debt + Total Equity
= $40 million + (3 million shares * $20 per share)
= $40 million + $60 million
= $100 milion

Debt Proportion = Debt / Total Capital = $40 million / $100 million = 0.4
Equity Proportion = Equity / Total Capital = $60 million / $100 million = 0.6

2) Cost of Equity/Debt

Cost of Debt after tax = Cost of Debt * (1-tax rate)
= 5% * (1-34%)
   = 3.3%

Cost of Equity = Risk Free Rate + (Beta * Market Risk Premium)
= 1% + ( 1.41 * 9.5%)
= 1% + 13.395%
= 14.395%

WACC = (Cost of Equity * Equity Proportion) + (Cost of Debt after tax * Debt Proportion)
= (14.395% * 0.6) + (3.3% * 0.4)
= 8.637% + 1.32%
= 9.957%

Ans : The firm's weighted average cost of capital is 9.957%