Given are the following dа ta: Cost of debt = rD = 6.0%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50% debt and 50% equity. Calculate the after-tax weighted average cost of capital (WACC) :

Question

Chico

Business

3 July, 10:20

Given are the following dа ta: Cost of debt = rD = 6.0%; Cost of equity = rE = 12.1%; Marginal tax rate = 35%; and the firm has 50% debt and 50% equity. Calculate the after-tax weighted average cost of capital (WACC) :

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Walter Strong · Answer 1

WACC = 8%

Explanation:

WACC is the minimum return that a company should make to on its investment to satisfy the providers of funds (i. e loan providers and equity holders). The rate usually reflect the riskiness of the of the investment and finance structure used.

Calculation

WACC = (MV of Equity:MV of the Company) Ke + (MV of Debt:MV of the Company) Kd (1-t).

Where:

MV of the Company ⇒ MV of Equity+MV of Company

Ke ⇒ Cost of Equity

Kd (1-t) ⇒ Cost of Debt after Tax

WACC = (50/100) 12.1% + (50/100) 6% (1-0.35)

= 6.05% + 1.95%

Hence, WACC = 8%

Implication of Captital Structure on WACC

Provided the investment was solely financed by equity instrument alone, the the WACC would have remained at 12.1%. However, with the introduction of debt finance, this has resuced our WACC to 8%.