Question

considering a project that requires an initial investment of $270,000. The firm will raise the $270,000 in capital by issuing $100,000 of debt at a before-tax cost of 9.6%, $30,000 of preferred stock at a cost of 10.7%, and $140,000 of equity at a cost of 13.5%. The firm faces a tax rate of 25%, what will be the WACC for this project?\

a. 11.97%       b. 13.73%       c. 9.04%         d. 10.86%

Answer 1

Answer: d) 10.86%

Weighted Average Cost of Capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.

Weight of each elements of capital structure can be find as follows ( all figures rounded off to two decimal point):

Debt = $ 1,00,000 / $ 2,70,000 = 0.37 (0.3703)

Preferred stock = $ 30,000 / $ 2,70,000 = 0.11 (0.1111)

Equity = $ 1,40,000 / $ 2,70,000 = 0.52 (0.5185)

Cost of capital of each elements of capital are as follows:

After tax cost of Debt = Interest × ( 1 - Tax)

= 9.6 % (1 - 0.25) = 7.2%

Cost of preferred stock = 10.7%

Cost of equity = 13.5%

WACC = (After Tax cost of Debt × weight of debt) + ( cost of preferred stock × weight of preferred stock) + ( cost of equity × weight of equity)

= (7.2% × 0.37) + (10.7% × 0.11) + ( 13.5% × 0.52)

= 2.664% + 1.177% + 7.02%

= 10.861% = 10.86% (rounded off)

WACC for this project is 10.86%