Suppose the cost of capital of the Gadget Company is 10 percent. If Gadget has a capital structure that is 50 percent debt and 50 percent equity, its before-tax cost of debt is 5 percent, and its marginal tax rate is 20 percent, then its cost of equity capital is closest to: 16 percent. 14 percent. 10 percent. 12 percent.

Question

Brian Mccormick

Business

27 July, 04:19

Suppose the cost of capital of the Gadget Company is 10 percent. If Gadget has a capital structure that is 50 percent debt and 50 percent equity, its before-tax cost of debt is 5 percent, and its marginal tax rate is 20 percent, then its cost of equity capital is closest to: 16 percent. 14 percent. 10 percent. 12 percent.

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Answers (1)

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Kiara Bolton · Answer 1

Cost of equity capital is closest to: 16 percent

Solution:

WACC is covered on page 120 Corporate Finance, under Capital Structure.

Using the standard equation for WACC = %wt Equity x cost of equity (re) + %wt Debt x cost of debt (rd).

Since there is a 20% tax rate for the firm, the cost of borrowing is reduced by that amount. So the cost of debt is 4%, not 5%.

Plug the formula: 10% = 50% x re + 50% x 4%

The formula (i. e. 0.1 + (0.1-0.05) (1) (1-0.2)) in CFAI reading is questionable.

The calculation is 0.1 + (0.1-0.05 * (1-0.2)) * (1) = 16%