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?

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Question restatement: 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?

Option 1: 7.00% — To evaluate, apply the WACC formula using weights: debt weight 40% and equity weight 60%. If the debt cost after tax is 5% and equity cost is 10%, the calculation would be 0.40 * 0.05 + 0.60 * 0.10. This yields 0.02 + 0.06 = 0.08, which is 8.00%. Therefore, 7.00% is too low since it omits either the debt or equity contribution correctly.

Option 2: 6.00% — This would imply an even smaller weighted contribution from either debt or equity than the 8% calculation. Since the given after-tax debt cost is 5% and equity cost is 10%, the weighted sum cannot drop to 6.00% without changing the weights or costs. Hence, 6.00% is inconsistent with the provided data.

Option 3: 9.00% — This would occur if the debt or equity terms were biased toward the higher-cost component. But with 40% of the capital at 5% and 60% at 10%, the combined rate cannot exceed 0.4*0.05 + 0.6*0.10 = 0.08. Therefore, 9.00% overstates the WACC given the inputs.

Option 4: 8.00% — This option matches the standard WACC calculation using the given weights and costs: WACC = (0.40 × 0.05) + (0.60 × 0.10) = 0.02 + 0.06 = 0.08, or 8%. This aligns with combining a 40% debt portion at 5% after-tax cost and a 60% equity portion at 10% cost.

Summary note: The key steps are identifying the capital structure weights (debt = 40%, equity = 60%), plugging in after-tax debt cost (5%) and cost of equity (10%), and performing the weighted sum to obtain 8.00%.

BUSFIN 3220 AU2025 (2910) 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?

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