Question

Practice Question 15 What would be a firm’s WACC if the risk free rate was 4%, the expected market return was 6%, the firm’s marginal tax rate was 35%, the firm has a beta of 1.5, its before-tax cost of debt was 6%, and its outstanding debt was valued at $1 million in the market, while its common shares were worth $6 million in the open market, and it had no preferred shares. 6.5% 6.86% 6.3% 6.56%

Answer 1

Answer: Correct answer is 6.56%
WACC=Weight of equity*Cost of equity+Weight of debt*Cost of debt*(1-tax rate)
Cost of equity=Risk free rate + Beta*(Market return-Risk free rate)
Given that the risk free rate=4%, market return=6% and beta=1.5
Cost of equity=4%+1.5*(6%-4%)
=4%+1.5*(2%)
=4%+0.03
=0.07

Value of debt outstanding=$1 million
value of common shares (or equity) outstanding=$6 million
Total value=($1+$6) million=$7 million
Weight of debt=Amount of debt/Total amount=$1/$7=0.142857143

Weight of equity=Amount of equity/Total amount=$6/$7=0.857142857
Before-tax cost of debt=6% and tax rate=35%
WACC=0.857142857*0.07+0.142857143*6%*(1-35%)
=0.857142857*0.07+0.142857143*6%*(0.65)
=0.06+0.005571429
=0.065571429 or 6.56% (Rounded to two decimal places)