Final answer:
The weighted average cost of capital (WACC) for The Two Dollar Store, given an 11.9% cost of equity, 6.2% YTM on bonds, 21% tax rate, and debt-equity ratio of 0.54, is calculated to be 9.46%.
Step-by-step explanation:
The student has asked how to calculate the weighted average cost of capital (WACC) for The Two Dollar Store, given a set of financial parameters including cost of equity, yield to maturity (YTM) on bonds, tax rate, and debt-equity ratio. To calculate WACC, one needs to combine the cost of equity and the cost of debt, each weighted by its proportion in the company's capital structure, where the cost of debt is adjusted for taxes. We can follow the formula:
WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc)
E is the market value of the equity,
D is the market value of the debt,
V equals E + D, the total market value of the company's financing (equity and debt),
Re is the cost of equity,
Rd is the cost of debt,
Tc is the corporate tax rate.
In this case, we have:
Cost of equity (Re) = 11.9%
Yield to maturity on the company's bonds (Rd) = 6.2%
Tax rate (Tc) = 21%
Debt-equity ratio (D/E) = 0.54
First, we need to convert the debt-equity ratio into the market value weights of equity (E/V) and debt (D/V). Given a debt-equity ratio (D/E) of 0.54, we can say:
D/V = 0.54 / (1 + 0.54) = 0.54 / 1.54 = 0.3506 or 35.06%
E/V = 1 / (1 + 0.54) = 1 / 1.54 = 0.6494 or 64.94%
Now, we can calculate the WACC:
WACC = (0.6494 × 0.119) + (0.3506 × 0.062 × (1 - 0.21))
Calculating this out:
WACC = 0.0773 + 0.0173 = 0.0946 or 9.46%
Therefore, the weighted average cost of capital for The Two Dollar Store is 9.46%.