A company's balance sheets show a total of $30 million long-term debt with a coupon rate of 9 percent. The yield to maturity on this debt is 11.11 percent, and the debt has a total current market value of $25 million. The balance sheets also show that that the company has 10 million shares of stock; the total of common stock and retained earnings is $30 million. The current stock price is $7.5 per share. The current return required by stockholders, rS, is 12 percent. The company has a target capital structure of 40 percent debt and 60 percent equity. The tax rate is 40%. What weighted average cost of capital should you use to evaluate potential projects

The weighted average cost of capital should you use to evaluate potential projects is 9.87%

Explanation:

Weighted average cost of capital (WACC) : The WACC shows the total proportion towards debt and equity.

The debt should always be calculated after considering tax.

The computation of weight-age average cost of capital is shown below:

For debt = Yield to maturity * (1 - tax rate)

= 11.11% * (1-0.40)

= 6.67%

For equity it is given in the question i. e = 12%

As, the capital structure is give, 40% is for debt and 60% is for equity. After considering these capital structure, the computation can be made.

= Cost of equity * weighted of equity + cost of debt * weight-age of debt

= 12% * 60% + 6.67% * 40%

= 7.2% + 2.67%

= 9.87%

Thus, the weighted average cost of capital should you use to evaluate potential projects is 9.87%.