Question

Consider a firm that has 18% of debt. The rate of return for debt is 6% and the rate of return for equity is 14%. The corporate tax rate is 40%. What is the weighted average cost of capital?

Answer 1

The firm's weighted average cost of capital (WACC) is calculated using the proportion of debt and equity, their respective costs, and the corporate tax rate. After accounting for the tax deductibility of debt, the firm's WACC comes out to be 12.128%.

Step-by-step explanation:

To calculate the weighted average cost of capital (WACC), we need to consider the proportion of debt and equity in the firm's capital structure, the cost associated with each, and the tax shield gained from the deductibility of interest payments. The firm in question has 18% of debt, meaning that equity represents 82% of the firm's capital structure. The cost of debt is 6%, and the cost of equity is 14%. The corporate tax rate is given as 40%.

The WACC is the weighted sum of the after-tax cost of debt and the cost of equity. The after-tax cost of debt is calculated as follows:

Cost of debt after tax = Cost of debt × (1 - Tax rate)
= 6% × (1 - 0.40)
= 3.6%

The weights of debt and equity are their respective percentages of the total capital. So, we use these weights and the costs to compute the WACC:

WACC = (Weight of debt × Cost of debt after tax) + (Weight of equity × Cost of equity)
= (0.18 × 3.6%) + (0.82 × 14%)
= 0.648% + 11.48%
= 12.128%

Therefore, the firm's WACC is 12.128%.