A firm finances itself with 30 percent debt, 60 percent common equity, and 10 percent preferred stock. The before-tax cost of debt is 5 percent, the firm's cost of common equity is 15 percent, and that of preferred stock is 10 percent. The marginal tax rate is 30 percent. What is the firm's weighted average cost of capital?

Question

Quizplus · Accepted Answer

Step 1: Calculate the cost of each capital component:
Cost of debt = 5%
Cost of common equity = 15%
Cost of preferred stock = 10%

Step 2: Calculate the weights of each capital component:
Weight of debt = 30%
Weight of common equity = 60%
Weight of preferred stock = 10%

Step 3: Calculate the after-tax cost of debt:
After-tax cost of debt = Before-tax cost of debt x (1 - Tax rate)
After-tax cost of debt = 5% x (1 - 30%)
After-tax cost of debt = 3.5%

Step 4: Calculate the weighted average cost of capital (WACC):
WACC = Weight of debt x Cost of debt x (1 - Tax rate) + Weight of common equity x Cost of common equity + Weight of preferred stock x Cost of preferred stock
WACC = 0.30 x 3.5% + 0.60 x 15% + 0.10 x 10%
WACC = 1.05% + 9% + 1%
WACC = 11.05%

Therefore, the best choice is B, 11.05 percent.

A Firm Finances Itself with 30 Percent Debt, 60 Percent