Question

Rogot Instruments makes fine violins and cellos. It has ​$1.7 million in debt​ outstanding, equity valued at ​$2.1 million and pays corporate income tax at rate 36 % . Its cost of equity is 14 % and its cost of debt is 6 % .

a. What is​ Rogot's pretax​ WACC?

b. What is​ Rogot's (effective​ after-tax) WACC?

Answer 1

The Weighted Average cost of capital ( WACC) is the rate that the company is expected to pay its holders( both debt and equity for the use of the funds). Thus this is the rate which is minimum to please the investors of the firm.

WACC = [(E/V) * Re] + [(D/V) * Rd * (1-Tc)]

• Re = cost of equity (expected rate of return on equity)
• Rd = cost of debt (expected rate of return on debt)
• E = market value of company equity D = market value of company debt
• V = total capital invested, which equals E + D
• E/V = percentage of financing that is equity
• D/V = percentage of financing that is debt
• Tc = corporate tax rate

Market value of company debt	E	$1,700,000
Market value of company Equiry	D	$2,100,000
Corporate tax	TC	36%
Cost of equity	Re	14%
Cost of debt	Rd	6%
Total capital invested	V	$3,800,000
Cost of financing equity	(E/V)*Re ($2,100,000 /$3,800,000)*14%	8%
Cost of Financing debt ( Pre tax)	(D/V)*Rd ($1,700,000/$3,800,000)*6%	3%
Cost of Financing debt ( Post tax)	(D/V)*Rd*(1-TC) 6% (1-36%)	2%

Thus

a. What is​ Rogot's pretax​ WACC?= Cost of equity (8%)+ Cost of debt pre tax (3%) = 11%

b. What is​ Rogot's (effective​ after-tax) WACC?=Cost of equity (8%)+ Cost of debt post tax (2%) = 10%