Question

The pre-tax cost of debt is 11%, preferred stock costs 14%, and equity costs 15%. What is the weighted average cost of capital assuming a tax rate of 40% and a target capital structure of 40% debt, 20% preferred stock, and 40% equity

Answer 1

Answer:

WACC is 11.4%

Explanation:

The weighted average cost of capital (WACC) is the average cost of all the various sources of long-term finance used by a business weighted according to the proportion which each source of finance bears to the the entire pool of fund.  

To calculate the weighted average cost of capital, follow the steps below:  

Step 1: Calculate cost of individual source of finance(this is already given)

Cost of Equity= 15%  

After-tax cost of debt:

= (1- T) × before-tax cost of debt

=  11%× (1-0.4)= 6.6%

Cost of preferred stock costs= 14%

Step 2 : calculate the proportion or weight of the individual source of finance . (This already given)

Equity = 40%  

Debt= 40%

Preferred stock : 20%

Step 3; Work out weighted average cost of capital (WACC)

WACC = ( 15%× 40%) + ( 6.6%× 40%) + (14%×  20%)= 11.4%

WACC is 11.4%