A firm's capital structure includes debt, 60% common stock, and no preferred stock. The after-tax cost of debt is 5%, and the cost of equity is 10%. What is the WACC?

Question

BlackTom AI · Accepted Answer

We start by identifying the capital structure weights and the corresponding costs given in the problem. The firm has debt and 60% common stock, with no preferred stock, which implies the equity weight is 60% and the debt weight is 40% (since 100% - 60% = 40%). The after-tax cost of debt is 5% and the cost of equity is 10%. The formula for WACC is: WACC = wd * rd(1 - T) + we * re, where wd is the weight of debt, rd is the cost of debt, T is the tax rate, we is the weight of equity, and re is the cost of equity.

Option by option analysis:
- Option 6.00%: If we compute using the given numbers, 0.40 * 0.05 = 0.02 (2%), and 0.60 * 0.10 = 0.06 (6%), summing to 0.08 (8%). Therefore, 6.00% would be too low because it omits the equity contribution entirely, which is 6 percentage points in this calculation.

- Option 8.00%: This matches the calculated WACC using wd = 0.40, rd = 0.05, we = 0.60, re = 0.10: 0.40 * 0.05 = 0.02, and 0.60 * 0.10 = 0.06; total = 0.08 or 8%. This is consistent with the standard WACC formula.

- Option 7.00%: This would arise if one of the components were misvalued. For example, using 0.40 * 0.05 = 0.02 and 0.60 * 0.10 = 0.05 would yield 0.07, but the cost of equity is stated as 10%, not 8% or 5%, so 7.00% ignores part of the equity contribution.

- Option 9.00%: This would occur if the debt portion were weighted more heavily or if both costs were attributed differently. However, with debt at 40% carrying 5% after-tax cost and equity at 60% carrying 10%, the sum cannot exceed 8% under the given inputs, making 9.00% inconsistent with the data.

In summary, the WACC derived from the provided capital structure and costs is 8%, since the debt contribution is 2 percentage points and the equity contribution is 6 percentage points, totaling 8%.

BUSFIN 3220 AU2025 (2110) Trial Exam 3 - Requires Respondus LockDown Browser

A firm's capital structure includes debt, 60% common stock, and no preferred stock. The after-tax cost of debt is 5%, and the cost of equity is 10%. What is the WACC?

View Explanation

Log in for full answers

Similar Questions

Calculate WACC before and after the restructuring. (As we did in class, make a simplifying assumption that your expected ROE is equal to cost of capital, Re)

(Continued) What is the cost of capital (WACC) after moving to a 30% debt ratio?

What is WACC of Big Oil?

Suppose that you just received the dividend of $2, which is expected to grow by 1% forever. What is the firm's WACC? Hint: Use dividend growth model in slide 4 of Week10 to calculate Re.

A company has no debt. Its cost of capital is 8.7 percent. Suppose the firm converts to a debt-equity ratio of 0.65. The interest rate on the debt is 6.9 percent. What is its new WACC?

More Practical Tools for International Students

Exam Browser Assistant

Stylized Writing Assistant

Plagiarism Checker Assistant

Citation Assistant

In-Class Translation Assistant

Class Notes Assistant

Quiz Search Assistant

Past Exam Questions by School

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler