Question

Aiden Ruby is trying to decide whether to invest in a new line of business and wants to calculate their WACC. Assume that their capital structure consists of 58% common stock, 12% preferred stock, and 30% debt. Further, analysts predict that their future cost of debt will be 6% and their cost of preferred stock is 11%. We predict that their beta is 3.55. The current risk-free rate is 3.2%, the expected return to the market is 7%, and the tax rate is 21%. What is this firm s WACC?

Answer 1

12.42%

Step-by-step explanation:

WACC is the average cost of capital of the firm based on the weightage of the debt and weightage of the equity multiplied to their respective costs.

According to WACC formula

WACC = ( Cost of equity x Weightage of equity ) + ( Cost of debt ( 1- t) x Weightage of debt ) + ( Cost of Preferred equity x Weightage of Preferred equity )

As per given data

Weights

Common Stock = 58%

Preferred Stock = 12%

Debt = 30%

Cost

Cost of Preferred Share = 11%

Cost of debt = 6%

Cost of Equity

Capital asset pricing model measure the expected return on an asset or investment. it is considered as the cost of common stock.

Formula for CAPM

Cost of Equity = Risk free rate + beta ( market return - risk free rate )

Cost of Equity = Rf + β ( Rm - Rf )

Cost of Equity = 3.2% + 3.55 ( 7% - 3.2% ) = 16.69%

Placing Values in the WACC formula

WACC = ( 16.69% x 58% ) + ( 6% ( 1- 0.21) x 30% ) + ( 11% x 12% )

WACC = 9.68% + 1.42% + 1.32 = 12.42%