Question

The company borrows money at 4% interest rate and the company pays income taxes at 25%...

The company borrows money at 4% interest rate and the company pays income taxes at 25% rate. Investors wish to earn 15% on its stock. The company has 1 Million shares of common stock outstanding currently trading at $15 per share. The company also has $5 Million debt (bond) outstanding. What is this company’s weighted average cost of capital?

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Answer #1

Market Value capital structures

Market Value of Debt = $5.00 Million

Market Value of Equity = $15.00 Million [1 Million common shares x $15.00 per share]

Total Market Value = $20.00 Million

Weight of Capital Structure

Weight of Debt = 0.25 [$5.00 Million / $20.00 Million]

Weight of Equity = 0.75 [$15.00 Million / $20.00 Million]

After-tax Cost of Debt

The After-tax Cost of Debt is the after-tax Interest rate

After Tax Cost of Debt = Interest rate x (1 – Tax Rate)

= 4.00% x (1 – 0.25)

= 4.00% x 0.75

= 3.00%

Cost of Equity = 15.00%

Weighted Average Cost of Capital (WACC)

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

= [3.00% x 0.25] + [15.00% x 0.75]

= 0.75% + 11.25%

= 12.00%

“Hence, the company’s weighted average cost of capital will be 12.00%”

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