Question

A firm has a capital structure with $7 in equity and $1 of debt. The cost of equity capital is 0.16 and the pretax cost of debt is 0.08. If the marginal tax rate of the firm is 0.3 compute the weighted average cost of capital of the firm.

Answer 1

0.147 or 14.7%

Step-by-step explanation:

Equity (E) =$7

Debt (D) = $1

Cost of equity capital (Ce) = 0.16

Pretax cost of debt (Cd) = 0.08

Tax rate (r) = 0.3

The weighted average cost of capital of the firm is given by the following relationship:

`WACC=(E)/(E+D)*C_e +(D)/(E+D)*C_d*(1-r)\\WACC = (7)/(7+1)*0.16 +(1)/(7+1)*0.08*(1-0.3)\\WACC= 0.14+0.007\\WACC =0.147 = 14.7\%`

The weighted average cost of capital of the firm is 0.147 or 14.7%.