Question

A company has a beta of 0.9, pre-tax cost of debt of 5% and an effective corporate tax rate of 20%. The weight of debt in its capital structure is 40% and the rest is equity. Suppose the current risk-free rate is 3% and the expected market return is 8%. What is this company's weighted average cost of capital?

Answer 1

The Weighted Average Cost of Capital (WACC) for the company is 6.1%, which is a blend of the cost of equity and the after-tax cost of debt, calculated using the company's beta, the risk-free rate of return, the expected market return, and the weights of equity and debt in the capital structure.

Step-by-step explanation:

Calculating the Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is calculated by combining the cost of equity and the cost of debt in proportion to their relative weights in the company's capital structure. Since the company has a beta of 0.9, and given the risk-free rate of 3% and the expected market return of 8%, we first calculate the cost of equity (using the Capital Asset Pricing Model - CAPM):

Cost of Equity = Risk-free rate + Beta x (Market return - Risk-free rate) = 3% + 0.9 x (8% - 3%) = 7.5%

The pre-tax cost of debt is given as 5%, and the company has an effective corporate tax rate of 20%. Therefore, the after-tax cost of debt can be calculated as follows:

After-tax Cost of Debt = Pre-tax cost of debt x (1 - Corporate tax rate) = 5% x (1 - 0.2) = 4%

With the weights of debt being 40% and equity representing 60% (100% - 40%), we can calculate the WACC:

WACC = (Cost of Equity x Weight of Equity) + (After-tax Cost of Debt x Weight of Debt) = (7.5% x 0.6) + (4% x 0.4) = 4.5% + 1.6% = 6.1%

So, the company's WACC is 6.1%.