Question

Assume that XYZ Corporation is a leveraged company with the following information:

Kl = cost of equity capital for XYZ = 13 percent
i = before-tax borrowing cost = 8 percent
t = marginal corporate income tax rate = 30 percent
If XYZ's debt-to-total-market-value ratio is 40 percent, then its weighted average cost of capital, K, is:

Question 3 options:

a 12 percent


b 10 percent


c 8 percent


d 9 percent

Answer 1

The weighted average cost of capital (WACC) for XYZ Corporation, with the given capital structure and costs, is calculated to be 10%. This is done using the WACC formula by incorporating the cost of equity, cost of debt, tax rate, and debt-to-equity ratio.

Step-by-step explanation:

The student is asking how to calculate the weighted average cost of capital (WACC) for a leveraged firm with given costs of equity and debt, tax rate, and debt-to-market value ratio. To find WACC, we can use the formula:

WACC = (E/V) * Ke + (D/V) * Kd * (1 - Tc)

Where:

• E = Market value of the firm's equity
• D = Market value of the firm's debt
• V = E + D = Total market value of the firm
• Ke = Cost of equity
• Kd = Cost of debt
• Tc = Corporate tax rate

Given the details:

• Ke (Kl) = 13%
• Kd (i) = 8%
• Tc (t) = 30%
• Debt-to-total-market-value ratio (D/V) = 40%, which implies equity ratio (E/V) is 60%

We can substitute these into the formula:

WACC = (0.60 * 0.13) + (0.40 * 0.08 * (1 - 0.30))

Calculating this:

WACC = 0.078 + 0.0224 = 0.1004 or 10.04%

Since WACC is expressed as a percentage, rounding this to the nearest whole percent gives us 10 percent.

Therefore, the correct answer is option b, 10 percent.