Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is 7.2%. Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any dividends. The stock sells for $24. Bonds are currently selling at par value. Compute Bay State's weighted cost of capital. A partial balance sheet is shown below: $$\begin{array} { l r }
\text { Current liabilities } & \$ 300,000 \
\text { Long-term debt } & \$ 1,000,000 \
\text { Common stock at } \$ 1 \text { par } & \$ 100,000 \
\text { Paid in capital } & \$ 900,000 \
\text { Retained earnings } & \$ 3,000,000 \
\text { Total liabilities and stockholders' equity } & \$ 5,300,000
\end{array}$$

Question

Bay State Technology has determined that its cost of equity is 15% and its after-tax cost of debt is 7.2%. Bay State expects to earn $14 million after taxes next year and, as a new firm, does not pay any dividends. The stock sells for $24. Bonds are currently selling at par value. Compute Bay State's weighted cost of capital. A partial balance sheet is shown below: $$\begin{array} { l r } 
\text { Current liabilities } & \$ 300,000 \
\text { Long-term debt } & \$ 1,000,000 \
\text { Common stock at } \$ 1 \text { par } & \$ 100,000 \
\text { Paid in capital } & \$ 900,000 \
\text { Retained earnings } & \$ 3,000,000 \
\text { Total liabilities and stockholders' equity } & \$ 5,300,000
\end{array}$$

Quizplus · Accepted Answer

The weighted cost of capital (WACC) is calculated by weighting the cost of equity and the cost of debt by their respective proportions in the total capital structure. The equity value is the sum of common stock, paid-in capital, and retained earnings, which equals $4,000,000 ($100,000 + $900,000 + $3,000,000). The total capital is the sum of equity and long-term debt, which equals $5,000,000 ($4,000,000 equity + $1,000,000 long-term debt). The weight of equity (We) is 0.8 ($4,000,000 / $5,000,000), and the weight of debt (Wd) is 0.2 ($1,000,000 / $5,000,000). The WACC is calculated as follows: WACC = (We * cost of equity) + (Wd * after-tax cost of debt) = (0.8 * 15%) + (0.2 * 7.2%) = 12% + 1.44% = 13.44%, which rounds to 13.4%.

Bay State Technology Has Determined That Its Cost of Equity