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 21%, 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 (WACC) is calculated by weighting the cost of each type of capital (equity, debt, preferred stock) by its proportion in the firm's capital structure and adjusting for taxes as applicable. The formula for WACC is: WACC = (E/V * Re) + ((D/V * Rd) * (1 - Tc)) + (P/V * Rp), where E = market value of equity, D = market value of debt, P = market value of preferred stock, V = E + D + P (total market value of the firm), Re = cost of equity, Rd = cost of debt, Rp = cost of preferred equity, and Tc = corporate tax rate.Given:- Equity proportion (E/V) = 70% or 0.7- Debt proportion (D/V) = 20% or 0.2- Preferred stock proportion (P/V) = 10% or 0.1- Re (pretax cost of equity) = 9%- Rd (pretax cost of debt) = 5%- Rp (pretax cost of preferred equity) = 7%- Tc (corporate tax rate) = 21%Plugging these values into the WACC formula gives:WACC = (0.7 * 0.09) + (0.2 * 0.05 * (1 - 0.21)) + (0.1 * 0.07) = 0.063 + 0.0079 + 0.007 = 0.0779 or 7.79%.Therefore, the WACC is between 7% and 8%.

Debreu Beverages Has an Optimal Capital Structure That Is 70