Question

A firm has a debt-to-equity ratio of 0.5 and a cost of equity capital of 12%. If its cost of debt is 8% and there is no tax, what is its weighted average cost of capital (WACC)?

A. 10%
B. 10.67%
C. 11.5%
Hint: Translate debt-to-equity ratio to weights of debt and of equity respectively.

Answer 1

To calculate the WACC, we first convert the debt-to-equity ratio to weights, then apply these weights to the respective costs. With a debt-to-equity ratio of 0.5, the WACC is calculated as 10.67%.

Step-by-step explanation:

The question requires calculating the weighted average cost of capital (WACC) for a firm with a given debt-to-equity ratio and specific costs of capital. First, the debt and equity weights need to be determined from the debt-to-equity ratio. With a ratio of 0.5, it implies that for every $1 of equity, there is $0.5 of debt. Therefore, the total value is $1 (equity) + $0.5 (debt) = $1.5, making the weight of debt 0.5/1.5 = 1/3 or 33.33% and the weight of equity 1/1.5 = 2/3 or 66.67%.

Next, we apply these weights to their respective costs:

• Cost of Debt = 8%
• Cost of Equity = 12%

The WACC formula is:

WACC = (Weight of Debt x Cost of Debt) + (Weight of Equity x Cost of Equity)

Plugging in the numbers:

WACC = (1/3 x 8%) + (2/3 x 12%)

WACC = (0.3333 x 0.08) + (0.6667 x 0.12)

WACC = 0.0267 + 0.08

WACC = 10.67%

Therefore, the correct answer is B. 10.67%.