Question

A. 17.2, B. 15.12 C.12% D. 18.7%

What would be the weighted average cost of capital for Lam Bakery, Inc. under the following conditions:

*The capital structure is 40% debt and 60% equity

*The before-tax cost of debt (which includes flotation costs) is 20% and the firm is in the 40% tax bracket

*The firm’s beta is 1.7

*The risk-free rate is 7% and the market risk premium is 6%

Answer 1

Option (B) is correct.

Step-by-step explanation:

Cost of Equity (Ke) = Rf + Beta ( Rp)

where,

Rf = risk free rate

Rp = Market risk premium

Hence,

Beta systematic risk :

= 7% + 1.7 (6%)

= 7% + 10.2%

= 17.2%

Post Tax cost of debt:

= Kd ( 1 - T)

where,

Kd = cost of debt

T = tax rate

= 20% * (1-0.4)

= 12%

WACC = [ (Ke × We) + (Wd × Kd(1-T)) ]

where,

We = weight of equity

Wd = weight of debt

= [(17.2% × 0.6) + (0.4 × 20% × (1 - 0.4))]

= 10.32% + 4.80%

= 15.12%