Wholesale Supply has earnings before interest and taxes of $148,600. Both the book and the market value of debt is $220,000. The unlevered cost of equity is 13.6 percent while the pretax cost of debt is 7.4 percent. The tax rate is 21 percent. What is the weighted average cost of capital?

Question

Quizplus · Accepted Answer

First, we need to calculate the weights of debt and equity:

Debt = Book value of debt = Market value of debt = $220,000 
Equity = Total assets - Debt = Total assets = EBIT/Unlevered cost of equity = $148,600/0.136 = $1,091,176.47

Total = Debt + Equity = $1,311,176.47

Weight of Debt = Debt/Total = $220,000/$1,311,176.47 = 0.1678 
Weight of Equity = Equity/Total = $1,091,176.47/$1,311,176.47 = 0.8322

Next, we can calculate the after-tax cost of debt:

After-tax cost of debt = Pretax cost of debt x (1 - Tax rate) = 0.074 x (1 - 0.21) = 0.05846

Finally, we can calculate the weighted average cost of capital (WACC) using the formula:

WACC = Weight of Debt x Cost of Debt + Weight of Equity x Cost of Equity

WACC = 0.1678 x 0.05846 + 0.8322 x 0.136 = 0.009794 + 0.1135312 = 0.1233252 or 12.33%

Rounding to two decimal places, the answer is 12.91%, which is option C.

Wholesale Supply Has Earnings Before Interest and Taxes of $148,600