Question

A firm's target capital structure is 40 percent debt and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm's marginal tax rate is 20 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium approach to find the cost of retained earnings (note that retained earnings is internally generated equity). The firm uses no preferred stock.

Required:
1. Calculate the firm's weighted average cost of capital (WACC).

Answer 1

The firm's weighted average cost of capital (WACC) is 13.44%

Step-by-step explanation:

According to the given data we have the following:

YTM = 12% = Pretax Cost of Debt

Cost of Equity = 12% + 4% = 6%

Therefore, to calculate the firm's weighted average cost of capital (WACC) we would have to use the following formula:

WACC = Weight of debt * Pretax cost of debt * (1 - Tax) + Weight of equity * Cost of Equity

WACC = 40% * 12% * (1 - 20%) + 60% * 16%

WACC = 13.44%