Question

Given are the following data: 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):

Answer 1

WACC = 8%

Step-by-step 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%.