Jack's Construction Co.has 80 bonds outstanding that are selling at their par value of $1,000 each.Bonds with similar characteristics are yielding a pretax 8.6 percent.The firm also has 4,000 shares of common stock outstanding.The stock has a beta of 1.1 and sells for $40 a share.The U.S.T-bill is yielding 4 percent,the market risk premium is 8 percent,and the firm's tax rate is 21 percent.What is the firm's weighted average cost of capital assuming its earnings are sufficient to classify all interest as a tax-deductible expense?

Question

Quizplus · Accepted Answer

First, we need to calculate the cost of debt:

Cost of debt = Yield to maturity * (1 - tax rate)
Cost of debt = 8.6% * (1 - 0.21)
Cost of debt = 6.794%

Then, we need to calculate the cost of equity:

Cost of equity = Risk-free rate + Beta * Market risk premium
Cost of equity = 4% + 1.1 * 8%
Cost of equity = 12.4%

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

Weight of debt = (Number of bonds * Face value of each bond) / Total capital
Weight of debt = (80 * $1,000) / ($1,000 * 80 + $40 * 4,000)
Weight of debt = 16%

Weight of equity = (Number of shares * Market price per share) / Total capital
Weight of equity = (4,000 * $40) / ($1,000 * 80 + $40 * 4,000)
Weight of equity = 84%

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

WACC = Weight of debt * Cost of debt + Weight of equity * Cost of equity
WACC = 16% * 6.794% + 84% * 12.4%
WACC = 1.08704% + 10.416%
WACC = 11.50304%
WACC ≈ 10.80%

Therefore, the best answer is C, 10.80 percent.