M&M Proposition 2: Rubber Chicken Inc. currently has a capital structure that is 40% debt and 60% equity. If the firm's cost of equity is 12%, the cost of debt is 8%, and the risk-free rate is 3%, what is the appropriate WACC?

Question

Quizplus · Accepted Answer

First, we need to calculate the after-tax cost of debt using the formula: cost of debt x (1 - tax rate). If the tax rate is not given, we assume it to be 35%.

After-tax cost of debt = 8% x (1 - 0.35) = 5.2%

Next, we can use the WACC formula:

WACC = (E/V x Re) + (D/V x Rd x (1 - T))

where:
E = market value of equity
D = market value of debt
V = total market value (D + E)
Re = cost of equity
Rd = cost of debt
T = tax rate

In this case, we can assume that the market value of debt and equity are equal to their book values:

E = 60%
D = 40%

So, V = E + D = 100%

Plugging in the given values, we get:

WACC = (0.6 x 0.12) + (0.4 x 0.052) = 0.104 or 10.4%