Question

Jemisen's firm has expected earnings before interest and taxes of $1,800. Its unlevered cost of capital is 11 percent and its tax rate is 33 percent. The firm has debt with both a book and a face value of $2,500. This debt has a 6 percent coupon and pays interest annually. What is the firm's weighted average cost of capital? 10.23 percent 10.29 percent 10.76 percent 10.46 percent 11.14 percent

Answer 1

Answer is 10.23%

Value of Unlevered Firm = EBIT * (1 - tax) / Unlevered Cost of Capital
Value of Unlevered Firm = $1,800 * (1 - 0.33) / 0.11
Value of Unlevered Firm = $10,963.64

Value of Levered Firm = Value of Unlevered Firm + Value of Debt * tax
Value of Levered Firm = $10,963.64 + $2,500.00 * 0.33
Value of Levered Firm = $11,788.64

Value of Equity = Value of Levered Firm - Value of Debt
Value of Equity = $11,788.64 - $2,500.00
Value of Equity = $9,288.64

Weight of Debt = Value of Debt / Value of Levered Firm
Weight of Debt = $2,500.00 / $11,788.64
Weight of Debt = 0.2121

Weight of Equity = Value of Equity / Value of Levered Firm
Weight of Equity = $9,288.64 / $11,788.64
Weight of Equity = 0.7879

Debt-Equity Ratio = Value of Debt / Value of Equity
Debt-Equity Ratio = $2,500.00 / $9,288.64
Debt-Equity Ratio = 0.26915

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (Debt-Equity Ratio) * (1 - tax)
Levered Cost of Equity = 0.11 + (0.11 - 0.06) * 0.26915 * (1 - 0.33)
Levered Cost of Equity = 0.1190 or 11.90%

WACC = Weight of Debt * Cost of Debt * (1 - tax) + Weight of Equity * Levered Cost of Equity
WACC = 0.2121 * 6.00% * (1 - 0.33) + 0.7879 * 11.90%
WACC = 10.23%