Question

A firm uses only debt and equity in its capital structure. The firm's weight of equity is 70 percent. The firm's cost of equity is 13 percent and it has a tax rate of 30 percent. If the firm's WACC is 11 percent, what is the firm's before-tax cost of debt?
a) 7.17 percent
b) 9.05 percent
c) 6.38 percent
d) 5.36 percent

Answer 1

Answer:

b) 9.05 percent

Explanation:

The computation of the firm before tax cost of debt is shown below:

The Weight of debt is

= 100 - 70

=30%

Now  

WACC = Respective cost × Respective weight

11 = (0.7 × 13) + (0.3 × Cost of debt)

11 = 9.1 + (0.3 × Cost of debt)

Cost of debt = (11 - 9.1) ÷ 0.3

= 6.333%(Approx)

Now

Pre-tax Cost of debt is

= Cost of debt ÷ (1 - tax rate)

= 6.333 ÷ (1 - 0.3)

= 9.05%

hence, the correct option is b.