Question

The firm's tax rate is 34 percent. The firm's pre-tax cost of debt is 8 percent; the firm's debt-to-equity ratio is 3; the risk-free rate is 3 percent; the beta of the firm's common stock is 1.5; the market risk premium is 9 percent. Calculate the weighted average cost of capital. Multiple Choice 33.33 percent 16.5 percent 8.09 percent 9.02 percent

Answer 1

Answer:

WACC = 0.08085  or  8.085% rounded off to 8.09%

Option c is the correct answer.

Explanation:

The WACC or weighted average cost of capital is the cost of a firm's capital structure that can contain one or more of the following components, namely debt, preferred stock and common equity. The formula to calculate the WACC is as follows,

WACC = wD * rD * (1-tax rate)  +  wP * rP  +  wE * rE

Where,

• w represents the weight of each component
• D, P and E represents debt, preferred stock and common equity respectively
• r represents the cost of each component

We first need to calculate the weight of each stock. We know the basic accounting equation is,

Assets = Debt + Equity

We know the debt to equity ratio is 3. Then total assets will be,

Assets = 3 + 1

Assets = 4

Using the CAPM equation, we can calculate the cost of equity.

r = risk free rate  +  Beta  *  Market risk premium

r = 0.03  +  1.5  *  0.09

r = 0.165  or  16.5%

WACC = 3/4  *  0.08  *  (1 - 0.34)  +  1/4  *  0.165

WACC = 0.08085  or  8.085% rounded off to 8.09%