Question

You would like to estimate the weighted average cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 10%. However, the new business will be 22% debt financed, and you anticipate its debt cost of capital will be 6%. If its marginal corporate tax rate is 31% and effective tax rate is 20%.

Required:
What is your estimate of its WACC?

Answer 1

Answer: 9.32%

Step-by-step explanation:

The cost of levered capital is needed to calculate WACC.

Cost of levered capital = Cost of unlevered capital + (Cost of unlevered capital - cost of debt)(1 - tax) * Debt to equity ratio

Debt-equity ratio

= 22% / (100% - 22%)

= 28.205%

Cost of levered capital = 10% + (10% - 6%) * (1 - 31%) * 28.205%

= 10.78%

WACC = (Weight of debt * after tax cost of debt) + (Weight of capital * cost of capital)

= (22% * 6% *(1 - 31%)) + (78% * 10.78%)

= 9.32%