The Lever Crowbar Company has a target capital structure of 70 percent debt and 30 percent equity with no preferred stock. The firm doesn't plan to raise equity capital beyond next year's retained which have a cost of 15%. Debt costs the company 8 percent before taxes of 40%. What is Lever's weighted average cost of capital.

Question

The Lever Crowbar Company has a target capital structure of 70 percent debt and 30 percent equity with no preferred stock.  The firm doesn't plan to raise equity capital beyond next year's retained which have a cost of 15%.  Debt costs the company 8 percent before taxes of 40%. What is Lever's weighted average cost of capital.

Quizplus · Accepted Answer

First, find the after-tax cost of debt:

Cost of Debt = 8% × (1 - 0.40) = 4.8%

Next, calculate the cost of equity using the CAPM:

Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium
Cost of Equity = 6% + 1.2 × 5% = 12%

Weight the costs of debt and equity based on the target capital structure:

Weighted Average Cost of Capital (WACC) = Weight of Equity × Cost of Equity + Weight of Debt × Cost of Debt
WACC = 0.3 × 12% + 0.7 × 4.8%
WACC = 7.86%

Therefore, the best choice is D, with a WACC of 7.86%.

The Lever Crowbar Company Has a Target Capital Structure of 70