Final answer:
Using the Capital Asset Pricing Model and the given target capital structure, we calculate the cost of equity and after-tax cost of debt to determine ABC Company's weighted-average cost of capital. The result of this calculation is approximately 7.4%, which is option B of the proposed answers.
Step-by-step explanation:
The student is asking for assistance in calculating ABC Company's weighted-average cost of capital (WACC). To determine the WACC, we need to consider both the cost of equity and the cost of debt, factoring in the given target capital structure. The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), which is represented as the risk-free rate plus the product of the company's beta and the market risk premium (expected market return - risk-free rate).
Applying the CAPM formula:
Cost of Equity = Risk-free rate + (Beta × (Expected market return - Risk-free rate))
= 4.00% + (0.90 × (9.00% - 4.00%))
= 4.00% + (0.90 × 5.00%)
= 4.00% + 4.50%
= 8.50%
The after-tax cost of debt is calculated by adjusting the bond yield-to-maturity with (1 - tax rate):
After-tax cost of Debt = Bond yield-to-maturity × (1 - Tax rate)
= 8.00% × (1 - 0.40)
= 8.00% × 0.60
= 4.80%
With the target capital structure of 70% common equity and 30% debt, the WACC can be computed as follows:
WACC = (Proportion of equity × Cost of equity) + (Proportion of debt × After-tax cost of debt)
= (0.70 × 8.50%) + (0.30 × 4.80%)
= 5.95% + 1.44%
= 7.39%
This result, rounded to one decimal place, gives us a WACC closest to 7.4%, which corresponds to option B.