Question

ABC Corp's combined marginal state, local, and federal tax rate was 35%. The 10-year Treasury bond rate is 2% and the borrowing rate for companies exhibiting similar levels of creditworthiness is 6%. The historical risk premium for stocks over the risk free rate of return is 5.5%. The firm's beta was estimated to be 1.1. The firm's debt to equity ratio is 20%.

The after-tax cost of debt of the firm is _____

The cost of equity of this firm is ______

The weighted average cost of capital (WACC) of this firm is ________

Answer 1

- Before-Tax Cost of debt = Borrowing rate for companies exhibiting similar levels of creditworthiness which is equal to 6%

After-Tax Cost of debt = Before-Tax Cost of debt *(1-Tax Rate)

After-Tax Cost of debt = 6%*(1-0.35)

a). After-Tax Cost of debt = 3.90%

b). As per CAPM,

where, rf = Risk free return = 2%

Rmp = Market Risk Premium = 5.5%

Beta of stock = 1.1

Required rate of return or Cost of equity = 2% + 1.1(5.5%)

Cost of equity = 8.05%

c). Debt-to-Equity ratio = 20%,i.e., 0.20-to-1

Debt Portion is 0.20 while Equity portion is 1

Total Capital structure = 0.20 + 1 = 1.20

Calculating WACC:-

WACC= (Weight of Debt)(After-Tax Cost of Debt)+ (Weight of Equity)(Cost of Equity)

WACC = (0.20/1.20)(3.90%) + (1/1.20)(8.05%)

WACC = 0.65% + 6.70833%

WACC = 7.36%

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