Question

6. Sierra Inc has a capital structure of 30% debt and 70% common equity, with no preferred stock. With a cost of retained earnings of 13%, a tax rate of 40%, find the cost of debt, rd, given a WACC of 9.96%.

Answer #1

Solution: | ||||

The cost of debt ( rd ) = 4.78% | ||||

Working Notes: | ||||

WACC= (Wd)(rd)(1 – T) + (We)(rs) | ||||

WACC= 9.96% | ||||

weight of debt (Wd)=30% | ||||

Weight of equity (We)= 70% | ||||

cost of debt ( rd )=?? | ||||

T = tax rate = 40% | ||||

rs = cost of equity = 13% | ||||

WACC= (Wd)(rd)(1 – T) + (We)(rs) | ||||

9.96% = 30% x rd x (1-.40) + 70% x 13% | ||||

9.96% = 30% x rd x 0.60 + 70% x 13% | ||||

9.96% = 18% x rd + 9.1% | ||||

rd = (9.96% - 9.1%)/18% | ||||

rd=0.04777 | ||||

rd =4.78% | ||||

let check it | ||||

WACC= (Wd)(rd)(1 – T) + (We)(rs) | ||||

=0.30 x 4.78% x 0.60 + 0.70 x 13% | ||||

= 9.9604 | ||||

=9.96% | ||||

Please feel free to ask if anything about above solution in comment section of the question. |

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