The firm's tax rate is 34 percent.The firm's pre-tax cost of debt is 8 percent; the firm's debt-to-equity ratio is 3; the risk-free rate is 3 percent; the beta of the firm's common stock is 1.5; the market risk premium is 9 percent.Calculate the weighted average cost of capital.

Question

Quizplus · Accepted Answer

The weighted average cost of capital (WACC) is calculated using the formula: WACC = [(E/V) * Re] + [(D/V) * Rd * (1-Tc)], where E is the market value of the equity, D is the market value of the debt, V = E + D is the total market value of the firm's financing (equity and debt), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. Given the firm's debt-to-equity ratio is 3, for every $1 of equity, there is $3 of debt. Thus, if E = 1, then D = 3, and V = 1 + 3 = 4. The cost of equity (Re) can be calculated using the Capital Asset Pricing Model (CAPM), which is Re = Risk-free rate + Beta * (Market risk premium) = 3% + 1.5 * 9% = 16.5%. The after-tax cost of debt (Rd*(1-Tc)) is 8% * (1-0.34) = 5.28%. Plugging these values into the WACC formula gives WACC = [(1/4) * 16.5%] + [(3/4) * 5.28%] = 4.125% + 3.96% = 8.085%, rounded to 8.09%.

The Firm's Tax Rate Is 34 Percent