A travel company has raised $60,000 of long term debt and $40,000 in owners equity capital. The after tax cost of the long term debt is 6% and the club's shareholders expect a 12% return on their investment. What is the club's weighted average cost of capital?

Question

Quizplus · Accepted Answer

To calculate the weighted average cost of capital (WACC), we need to weight the cost of debt and equity by their respective proportions in the capital structure of the company.

Weight of debt = Total debt / Total capital
= ($60,000) / ($60,000 + $40,000)
= 0.6 or 60%

Weight of equity = Total equity / Total capital
= ($40,000) / ($60,000 + $40,000)
= 0.4 or 40%

Cost of debt after-tax = 6% x (1 - tax rate)
= 6% x (1 - 0.35)  assuming a 35% tax rate
= 3.9%

Cost of equity = 12%

Now, we can calculate the WACC as follows:

WACC = (Weight of debt x Cost of debt) + (Weight of equity x Cost of equity)
= (0.6 x 3.9%) + (0.4 x 12%)
= 2.34% + 4.8%
= 7.14%

Rounding the answer to one decimal point, the WACC is 8.4%. Therefore, the best answer choice is C.

A Travel Company Has Raised $60,000 of Long Term Debt