Question

8. Your company's beta is 1.5 and market is 9%. In the same time treasury bill return is 4%. You have $300,000 Equity in the firm. You have $200,000 debt in your firm. The before tax cost of debt is 6%. The average tax rate is 40%. What is weighted average cost of capital of your firm?

Answer 1

Solution:
	weighted average cost of capital is 8.34%
Working Notes:
	For calculation of WACC    weighted average cost of capital
	The cost of debt is 6%,
	After tax cost of debt (Kd) = Cost of debt x (1- tax rate)
	= 6% x ( 1-0.40)
	=3.60%
Now	Cost of equity Ke using CAPM
	Cost of common equity (Ke)= rf + (rm - rf) x B
	rf = risk free rate = 4%
	rm= return of market =9%
	Beta = 1.50
	Cost of common equity (Ke)= rf + (rm - rf) x B
	= 4% + (9% -4%) x 1.5
	= 4% + 5% x 1.50
	= 4% + 7.50%
	Ke=11.50%
	Formulation for weighted average cost of capital is given below
	WACC= Ke x E/V + Kd   x D/V
	E= Value of Equity = $300,000
	D= Value of debt =$200,000
	V=value of the firm = E + V = $300,000 + $200,000 =$500,000
	E/V =   300,000/500,000 = 0.60
	D/V = 200,000/500,000 = 0.40
At last
	WACC= Ke x E/V + Kd   x D/V
	= 11.50% x 0.60 + 3.60% x 0.40
	=0.0834
	8.34%
Please feel free to ask if anything about above solution in comment section of the question.