Olden Company has a tax rate of 40 percent. Information for the company is as follows: Amount After-tax Cost
Mortgage bonds $1,000,000 0.048
Unsecured bonds 3,000,000 0.050
Common stock 6,000,000 0.150
What is the weighted average cost of capital?
A) 0.0827
B) 0.2480
C) 0.1098
D) 0.0366

Question

Quizplus · Accepted Answer

To calculate the weighted average cost of capital (WACC), we need to first calculate the after-tax cost of each source of financing.

For the mortgage bonds, the after-tax cost is 0.048 x (1 - 0.40) = 0.0288. 
For the unsecured bonds, the after-tax cost is 0.050 x (1 - 0.40) = 0.03. 
For common stock, the after-tax cost is 0.15 x (1 - 0.40) = 0.09.

Next, we need to calculate the proportion of each source of financing in the company's capital structure. The total capital structure is $10,000,000 ($1,000,000 + $3,000,000 + $6,000,000).

The proportion of mortgage bonds is $1,000,000/$10,000,000 = 0.1. 
The proportion of unsecured bonds is $3,000,000/$10,000,000 = 0.3. 
The proportion of common stock is $6,000,000/$10,000,000 = 0.6.

Finally, we can calculate the WACC using the formula:

WACC = (proportion of mortgage bonds x after-tax cost of mortgage bonds) + (proportion of unsecured bonds x after-tax cost of unsecured bonds) + (proportion of common stock x after-tax cost of common stock)

WACC = (0.1 x 0.0288) + (0.3 x 0.03) + (0.6 x 0.09) = 0.1098, or 10.98%.

Therefore, the best choice is (C).

Olden Company Has a Tax Rate of 40 Percent