A firm that's subject to a 40 percent tax rate has debt of $60M, equity of $140M, and no preferred stock. What is the firm's cost of capital (WACC)if its pretax cost of new debt is 12 percent, the pretax cost of its old debt is 8%, and its cost of equity is 14.5 percent?

Question

Quizplus · Accepted Answer

First, we need to calculate the weight of each type of financing.
Weight of debt = $60M / ($60M + $140M) = 0.3 or 30%
Weight of equity = $140M / ($60M + $140M) = 0.7 or 70%

Next, we need to calculate the after-tax cost of debt. Since the firm is subject to a 40% tax rate, the after-tax cost of new debt is:
12% x (1 - 0.4) = 7.2%

Using the formula for WACC:
WACC = (Weight of debt x After-tax cost of debt) + (Weight of equity x Cost of equity)
WACC = (0.3 x 7.2%) + (0.7 x 14.5%)
WACC = 2.16% + 10.15%
WACC = 12.31%

Therefore, the answer is choice C - 12.31%.

A Firm That's Subject to a 40 Percent Tax Rate