Jensen's weighted average cost of capital is 11.3%. Option C is the right choice.
The cost of equity is the return investors expect on the firm's common stock.
Formula using to calculate cost of equity :
Cost of equity = (EBIT * (1 - Tax rate) + (Debt * Coupon rate * (1 - Tax rate))) / (EBIT * (1 - Tax rate) + Debt)
where:
EBIT = Expected earnings before interest and taxes
Tax rate = The firm's tax rate
Debt = The book value of the firm's debt
Coupon rate = The interest rate on the firm's debt
Substituting values in this formula
Cost of equity = (6200 * (1 - 0.34) + (2500 * 0.09 * (1 - 0.34))) / (6200 * (1 - 0.34) + 2500) = 0.141
Calculate the cost of debt.
The interest rate the company pays on its debt is known as the cost of debt. In this case, the cost of debt is simply the coupon rate of 9%.
The weight of equity is the proportion of the firm's capital that is financed by equity. The weight of debt is the proportion of the firm's capital that is financed by debt. We can calculate these weights using the following formulas:
Weight of equity = EBIT * (1 - Tax rate) / (EBIT * (1 - Tax rate) + Debt)
Weight of debt = Debt / (EBIT * (1 - Tax rate) + Debt)
Substituting values in this formula
Weight of equity = 6200 * (1 - 0.34) / (6200 * (1 - 0.34) + 2500) = 0.789
Weight of debt = 2500 / (6200 * (1 - 0.34) + 2500) = 0.211
The WACC is the average cost of the firm's capital, taking into account the cost of both equity and debt and the weights of each.
Formula we are using is;
WACC = Cost of equity * Weight of equity + Cost of debt * Weight of debt
Substituting values in this formula
WACC = 0.141 * 0.789 + 0.09 * 0.211 = 0.113
Therefore, Jensen's weighted average cost of capital is 11.3%.
Option C is the right choice.
Question:-
Jensen's has expected earnings before interest and taxes of $6,200. Its unlevered cost of capital is 14 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital?
A. 14.14 percent
B. 13.87 percent
C. 11.3 percent
D. 12.48 percent
E. 13.60 percent