Question

Hartley Psychiatric, Inc., needs to purchase office equipment for its 2,000 drive-in therapy centers nationwide. The total cost of the equipment is $2,000,000. It is estimated that the aftertax cash inflows from the project will be $210,000 annually forever. Hartley has a debt-to-value ratio of 60 percent. The firm's cost of equity is 13 percent and its pre-tax cost of debt is 8 percent. The tax rate is 34 percent. What is Hartley's weighted average cost of capital (WACC)?A) 6.09 percentB) 8.37 percentC) 8.95 percentD) 9.05 percentE) 9.91 percent

Answer 1

Answer:

None of the above

The weighted average cost of capital is 10.8%

Explanation:

The formula for calculating the weighted average flotation costs is

fA = fE x RE + fD x RD x (1-Tc)

Where fA is the weighted average flotation cost

fE is the flotation cost of equity = 8%

fD is the flotation cost of debt =2%

RE is the cost of equity = 13%

RD is the cost of debt = 8%

Tc is the tax rate = 34%

Substituting these values in the above equation, we get

fA = 0.08 x 0.13 + 0.02 x 0.08 x (1-0.34)

= 0.0104 + 0.001056

= 0.11456 or 11.456%

Therefore, the weighted average flotation cost are 11.456%

Givent he debt-equity ratio is 60% or 0.6

We know that Debt + Equity = 100% or 1.0

The value of debt(D/V) = 0.6 / 1.60 = 0.375

The value of equity (E/V) = 1 / 1.60 = 0.625

Calculating the weighted average cost of capital

WACC = (E/V) x RE + (D/V) x RD x (1 - Tc)

         = 0.625 x 0.13 + 0.375 x 0.08 x 0.66

         = 0.09282 + 0.0151

         = 0.10792 or 10.792%

Therefore, the weighted average cost of capital is 10.8%