Question

Jemisen's firm has expected earnings before interest and taxes of $2,000. Its unlevered cost of capital is 14 percent and its tax rate is 34 percent. The firm has debt with both a book and a face value of $2,600. This debt has a 9 percent coupon and pays interest annually. What is the firm's weighted average cost of capital? 13.03 percent 13.33 percent 12.80 percent 13.71 percent 12.86 percent

Answer 1

Value of Unlevered firm = [ EBIT x (1 - tax rate) ] / unlevered cost of capital = [ $2000 x (1 - 0.34) ] / 0.14 = $9428.57142857 or $9428.5714

Now, as per M&M proposition I with taxes, we have -

Value of Levered firm = Value of unlevered firm + Value of Debt x Tax rate = $9428.5714 + $2600 x 34% = $10,312.5714

Also, Value of Equity = Value of Levered firm - Value of Debt = $10,312.5714 - $2600 = $7,712.5714

Next, we need to compute cost of equity -

Cost of Equity = Unlevered Cost of Capital + [ (Unlevered cost of capital - Cost of Debt) x (Value of debt / Value of equity) x (1 - tax rate) ]

or, Cost of Equity = 14% + [ (14% - 9%) x ($2600 / $7712.5714) x (1 - 0.34) ] = 15.112469% or 15.1125%

After tax cost of debt = 9% x (1 - 0.34) = 5.94%

WACC

WACC = Cost of Equity x Weight of Equity + After tax cost of Debt x Weight of Debt

or, WACC = [ 15.1125% x ($7712.5714 / $10312.5714) ] + [ 5.94% x ($2600 / $10312.5714) ] = 12.7999% or 12.80%