Master Company has 3 million shares of common stock trading at $50 dollars per share on which investors expect a return of 16%. The company also has debt with a market value of $70 million with a pretax cost of 7%. What is the weighted average cost of capital if the tax rate is 40%? Master has no preferred stock outstanding.

Question

Master Company has 3 million shares of common stock trading at $50 dollars per share on which investors expect a return of 16%. The company also has debt with a market value of $70 million with a pretax cost of 7%.   What is the weighted average cost of capital if the tax rate is 40%? Master has no preferred stock outstanding.

Quizplus · Accepted Answer

The weighted average cost of capital (WACC) is calculated by weighting the cost of equity and the after-tax cost of debt by their respective proportions in the total capital structure. The cost of equity (E/V * Re) is calculated as the market value of equity (number of shares * price per share) times the expected return on equity. The after-tax cost of debt (D/V * Rd * (1-T)) is the market value of debt times the pretax cost of debt times (1 minus the tax rate).Market value of equity (E) = 3 million shares * $50/share = $150 millionMarket value of debt (D) = $70 millionTotal value (V) = E + D = $150 million + $70 million = $220 millionCost of equity (Re) = 16%Pretax cost of debt (Rd) = 7%Tax rate (T) = 40%WACC = (E/V * Re) + (D/V * Rd * (1-T))= ($150 million / $220 million * 16%) + ($70 million / $220 million * 7% * (1-0.40))= (0.6818 * 16%) + (0.3182 * 7% * 0.6)= 10.909% + 0.891%= 11.8%

Master Company Has 3 Million Shares of Common Stock Trading