Debreu Beverages has an optimal capital structure that is 70% common equity, 20% debt, and 10% preferred stock. Debreu's pretax cost of equity is 9%. Its pretax cost of preferred equity is 7%, and its pretax cost of debt is also 5%. If the corporate tax rate is 35%, what is the weighted average cost of capital?
A) Between 7% and 8%
B) Between 8% and 9%
C) Between 9% and 10%
D) Between 10% and 12%

Question

Quizplus · Accepted Answer

The weighted average cost of capital is calculated as follows:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc) + (P/V) * Rpwhere:E = market value of common equityV = total market value of the firmRe = cost of common equityD = market value of debtRd = cost of debtTc = corporate tax rateP = market value of preferred stockRp = cost of preferred stockIn this case, we have:E/V = 0.7Re = 0.09D/V = 0.2Rd = 0.05Tc = 0.35P/V = 0.1Rp = 0.07Plugging these values into the formula, we get:WACC = (0.7 * 0.09) + (0.2 * 0.05 * (1 - 0.35)) + (0.1 * 0.07)= 0.063 + 0.007 + 0.007= 0.077Therefore, the weighted average cost of capital is 7.7%, which is between 7% and 8%.

Debreu Beverages Has an Optimal Capital Structure That Is 70