Question

# A company has \$400 million worth of debt outstanding with an average interest rate of 5%...

A company has \$400 million worth of debt outstanding with an average interest rate of 5% and 50 million common shares outstanding worth \$12 each. The company’s tax rate is 20%, beta is 1.3, the yield on 10-year Treasury notes is 1.5% and the expected market return is 9.5%. What is the company’s weighted average cost of capital (WACC) based on the current weights for debt and common stock in its capital structure?

Cost of equity = Risk-free rate + Beta(Market return - Risk-free rate)

Cost of equity = 0.015 + 1.3(0.095 - 0.015)

Cost of equity = 0.119 or 11.9%

Common equity = 50 million * \$12 = \$600 million

Weight of common equity = \$600 million / (\$400 million + \$600 million) = 0.60

Weight of debt = \$400 million / (\$400 million + \$600 million) = 0.40

WACC = (Weight of common stock * Cost of common equity) + [Weight of debt * Pretax cost of debt(1 - Tax)]

WACC = (0.60 * 0.119) + [0.40 * 0.05(1 - 0.20)]

WACC = 0.0874 or 8.74%

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