Question

The effect of tax rate on WACC

K. Bell Jewelers wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. The firm wishes to maintain a capital structure of 20​% ​debt, 20​% preferred​ stock, and 60 % common stock. The cost of financing with retained earnings is 16​%, the cost of preferred stock financing is 9​%, and the​ before-tax cost of debt financing is 8​%. Calculate the weighted average cost of capital ​(WACC​) given a tax rate of 40 %.

The​ firm's WACC is _?_% ​(Round to two decimal​ places.)

Answer 1

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is calculated by using the following formula

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

After Tax Cost of Debt = 4.80% [8.00% x (1 – 0.40)]

Weight of Debt = 20%

Cost of Preferred stock = 9.00%

Weight of preferred stock = 20%

Cost of equity = 16.00%

Weight of Equity = 60%

Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of Preferred stock x Weight of preferred stock] + [Cost of equity x Weight of Equity]

= (4.80% x 0.20) + (9.00% x 0.20) + (16.00% x 0.60)

= 0.96% + 1.80% + 9.60%

= 12.36%

“Hence, the firm's WACC is 12.36%”