Final answer:
To calculate Acme Storage's WACC, we need to consider the cost of equity and the cost of debt. Assuming a debt-equity ratio is maintained, the market value of equity is $100 million and debt is $40 million. By using the CAPM, the cost of equity is calculated as 11.4%. The after-tax cost of debt is 4.875%. Finally, the WACC is calculated as 9.5424%.
Step-by-step explanation:
To calculate the Weighted Average Cost of Capital (WACC) of Acme Storage, we need to consider the cost of equity and the cost of debt.
Since the debt–equity ratio is maintained at the same level, we can assume that the market value of equity is $100 million and the market value of debt is $40 million. This means the total market value of the firm is $140 million.
The cost of equity is the expected return demanded by the investors. To calculate this, we can use the Capital Asset Pricing Model (CAPM), which calculates the cost of equity using the risk-free rate, beta, and the market risk premium. Let's assume a risk-free rate of 3%, a beta of 1.2, and a market risk premium of 7%. Using these inputs, the cost of equity can be calculated as:
Cost of Equity = Risk-Free Rate + (Beta * Market Risk Premium)
= 3% + (1.2 * 7%)
= 11.4%
Next, we need to calculate the after-tax cost of debt. Since the interest rate on the debt is 7.5% and the corporate tax rate is 35%, the after-tax cost of debt can be calculated as:
After-Tax Cost of Debt = Interest Rate * (1 - Corporate Tax Rate)
= 7.5% * (1 - 35%)
= 4.875%
The weights of equity and debt in the capital structure can be calculated as:
Weight of Equity = Market Value of Equity / Total Market Value
= $100 million / $140 million
= 0.7143
Weight of Debt = Market Value of Debt / Total Market Value
= $40 million / $140 million
= 0.2857
Finally, we can calculate the WACC using the following formula:
WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * After-Tax Cost of Debt)
= (0.7143 * 11.4%) + (0.2857 * 4.875%)
= 8.1486% + 1.3939%
= 9.5424%