Final answer:
To determine Droz's Hiking Gear, Inc.'s after-tax weighted average cost of capital, the cost of equity (21.5%) and after-tax cost of debt (5.6%) are calculated and then weighted by their respective proportions in the capital structure (60% equity and 40% debt), resulting in a WACC of 15.14%.
Step-by-step explanation:
Calculating After-Tax Weighted Average Cost of Capital (WACC)
To calculate the after-tax weighted average cost of capital (WACC) for Droz’s Hiking Gear, Inc., we need to find the cost of equity, the after-tax cost of debt, and then use the market values of debt and equity to calculate their respective weights in the capital structure.
The cost of equity can be derived using the Capital Asset Pricing Model (CAPM). The formula for CAPM is: Cost of Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Plugging in the given values, we get: Cost of Equity = 9% + 2.5 * (14% - 9%) = 21.5%.
The cost of debt is given as the coupon rate of 8%. However, the after-tax cost of debt is lower because interest expenses are tax-deductible. Thus, we adjust the cost of debt for taxes using the formula: After-Tax Cost of Debt = Cost of Debt * (1 - Tax Rate). The after-tax cost of debt is 8% * (1 - 30%) = 5.6%.
With the market values given, we can calculate the weight of equity (We) and the weight of debt (Wd). The weight of equity is the market value of equity divided by the total market value of equity and debt, which is $120,000,000 / ($120,000,000 + $80,000,000) = 0.6 or 60%. Similarly, the weight of debt is $80,000,000 / ($120,000,000 + $80,000,000) = 0.4 or 40%.
Finally, we use the WACC formula: WACC = (We * Cost of Equity) + (Wd * After-Tax Cost of Debt). Substituting the values, we get: WACC = (0.6 * 21.5%) + (0.4 * 5.6%) = 12.9% + 2.24% = 15.14%.