Question

Given an optimal capital structure that is 50% debt and 50% common stock, calculate the weighted average cost of capital for the company given the following additional information:

Bond Coupon Rate = 8% Bond Yield to Maturity = 6% Dividend, expected = $5 Price, common = $80
Growth Rate = 5% Corporate Tax Rate = 30 %
A) Less than 5.0%.
B) More than 5.0% and less than 6.25%.
C) More than 6.25% and less than 7.5%.
D) More than 7.5%.

Answer 1

As the WACC is more than 7.5%, option D is the correct answer.

Step-by-step explanation:

The weighted average cost of capital or WACC is the cost of a firm's capital structure. To calculate the WACC, we multiply the weight of each component of the capital structure by the cost of that component. The components of capital structure can be one or all of the following namely debt, preferred stock and common stock.

The formula for WACC is,

WACC = wD * rD * (1-tax rate) + wP * rP + wE * rE

Where,

• w represents the weight of each component
• r represents the cost of each component
• D, P and E represents debt, preferred stock and common stock respectively

First we need to determine the cost of debt and equity for this firm.

We use the market value of debt and thus, rate for the calculation of WACC.

The cost of debt will be its yield to maturity as it is the current rate or cost. Thus, rD will be 6%.

The cost of equity can be determined using the constant growth model of DDM 's formula for prcie today.

P0 = D0 * (1+g) / (r - g)

80 = 5 * (1+0.05) / (r - 0.05)

80 * (r - 0.05) = 5.25

80r - 4 = 5.25

80r = 5.25 + 4

r = 9.25 / 80

r = 0.115625 or 11.5625%

WACC = 0.5 * 0.06 * (1-0.3) + 0.5 * 0.115625

WACC = 0.0788125 or 7.88125%

As the WACC is more than 7.5%, option D is the correct answer.