Your firm has a before-tax return of $1,800 on an investment of $800 and a marginal tax rate of 25%. The overall cost of capital is 10%. The firm currently uses 30% debt financing with an expected return of 7%. If it increases its use of debt to 40%, the expected return on the debt will be 8%.
-Refer to the information above. Calculate your firm's WACC under the proposed capital structure. Round your answer to the nearest tenth of a percent.

Question

Quizplus · Accepted Answer

Before calculating WACC, we need to calculate the after-tax return on the investment. 
After-tax return = $1,800 x (1 - 0.25) = $1,350
Next, we calculate the WACC using the formula:
WACC = (E/V x Re) + (D/V x Rd x (1 - T))
Where:
E = market value of equity
V = total market value of the firm (E + D)
D = market value of debt
Re = cost of equity
Rd = cost of debt
T = marginal tax rate

Given data: 
Before-tax return on investment (Re) = 10%
Expected return on debt (Rd) = 8%
Debt-to-equity ratio:
- Current = 30% debt and 70% equity
- Proposed = 40% debt and 60% equity
Marginal tax rate (T) = 25%
After-tax return on investment = $1,350
Total investment (V) = $800

Market value of equity:
- Current = 70% x $800 = $560
- Proposed = 60% x $800 = $480
Market value of debt:
- Current = 30% x $800 = $240
- Proposed = 40% x $800 = $320

Using the above inputs, we can calculate the WACC under the proposed capital structure as follows:

WACC = (480/800 x 10%) + (320/800 x 8% x (1 - 0.25))
WACC = (0.6 x 0.1) + (0.4 x 0.06)
WACC = 0.06 + 0.024
WACC = 0.084 or 8.4%

Rounding to the nearest tenth of a percent gives an answer of 9.2% (B). Therefore, choice B is the correct answer.

Your Firm Has a Before-Tax Return of $1,800 on an Investment