Question

Solve for the weighted average cost of capital.

13.60% = cost of equity capital for a leveraged firm

3/4 = debt-to-total-market-value ratio

8.0% = before-tax borrowing cost

21.0% = marginal corporate income tax rate

Answer 1

Cost of equity capital for a leveraged firm = 13.6 %

Before-tax borrowing cost = 8 %

Marginal corporate income tax rate = 21 % = 0.21

Debt-to-total-market-value ratio = 0.75

We know, Weight of Debt + Weight of Equity = 1

Hence, weight of equity = 1 - 0.75 = 0.25

where w_d = weight of debt in capital structure

r_d = before-tax cost of debt

w_e = weight of equity in capital structure

r_e = cost of equity

t = corporate tax rate

Putting all the values in above equation, we get

WACC = 0.75 * 13.6 % * ( 1 - 0.21) + 0.25 * 8 %

= 0.75 * 13.6 % * 0.79 + 2 %

= 8.058 % + 2 %

= 10.058 %