A firm requires an investment of $20,000 and borrows $10,000.If the return on equity is 20%,the tax rate is 30%,and the WACC is 12.8%,what is the firm's cost of debt?

Question

Quizplus · Accepted Answer

First, calculate the cost of equity using the formula: Cost of Equity = Return on Equity - ((Return on Equity - Cost of Debt) x (1 - Tax Rate))
Cost of Equity = 20% - ((20% - Cost of Debt) x (1 - 0.30))
Solve for Cost of Debt by substituting WACC with the weighted average of equity and debt costs: 
WACC = (Cost of Equity x Equity portion) + (Cost of Debt x Debt portion)
0.128 = (0.20 x 0.6667) + (Cost of Debt x 0.3333)
Cost of Debt = (0.128 - (0.20 x 0.6667)) / 0.3333 = 0.08 or 8%.

A Firm Requires an Investment of $20,000 and Borrows $10,000