Sam Jones has an engineering firm.He wants to build a new headquarters building.The building will cost $1,500,000.He will put down $450,000 and have a bank finance the remainder at prime plus 2 percent.The prime lending rate is currently 8.5 percent.Sam will withdraw the money for the down payment from his mutual fund account where he has earned 13% for the last ten years.What is Sam's weighted average cost of capital?

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Quizplus · Accepted Answer

The weighted average cost of capital is the average cost of all the sources of financing for a project. In this case, Sam is using two sources of financing: equity (the down payment) and debt (the bank loan). The cost of equity is the rate of return that Sam could have earned on the money if he had invested it in his mutual fund account. The cost of debt is the interest rate on the bank loan.The weighted average cost of capital is calculated as follows:WACC = (E / (D + E)) * Re + (D / (D + E)) * Rdwhere:WACC = weighted average cost of capitalE = equityD = debtRe = cost of equityRd = cost of debtIn this case, Sam is putting down $450,000 and borrowing $1,050,000. The cost of equity is 13% and the cost of debt is 8.5% + 2% = 10.5%.Therefore, the weighted average cost of capital is:WACC = (450,000 / (450,000 + 1,050,000)) * 13% + (1,050,000 / (450,000 + 1,050,000)) * 10.5%= 11.25%

Sam Jones Has an Engineering Firm