Question

Problem 5: You estimate that your pre-tax cost of debt is 10%. The firm is paying25% in taxes. The component cost for preferred stock is 20% and the cost of common equity is 25%. Assume that your target capital structure is comprised of 40% debt, 20% preferred stock, and 40% common stock. What is the firm’s WACC?

Answer 1

Target weight of debt= 40%

Target weight of equity= 40%

Target weight of preference shares= 20%

Pretax cost of debt= 10%

Cost of equity= 25%

Cost of preferred stock= 20%

The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+Wps*Kps+We*Ke

Where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.40*10%*(1- 0.25) + 0.20*20% + 0.40*25%

            = 3% + 4% + 10%

            = 17%.

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