Question

Reactive Power Generation has the following capital structure. Its corporate tax rate is 20%.

Security	Market Value			Required Rate of Return
Debt	$	20	million		4	%
Preferred stock		30	million		6
Common stock		50	million		10

What is its WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

Answer 1

Solution:         

As per the information given in the question

Market Value of debt = $ 20 Million            

Market Value of Preferred Stock = $ 30 Million  

Market Value of Common Stock = $ 50 Million   

Total Market value of the Securities = $ 20 Million + $ 30 Million + $ 50 Million = $ 100 Million

Thus Weight of Debt = [ Market value of debt / Total market value of all the securities ]

= $ 20 Million / $ 100 Million = 0.20

Thus Weight of Preferred Stock = [ Market value of Preferred Stock / Total market value of all the securities ]

= $ 30 Million / $ 100 Million = 0.30

Thus Weight of Common Stock = [ Market value of Common Stock / Total market value of all the securities ]

= $ 50 Million / $ 100 Million = 0.50

The formula for calculating the weighted average cost of capital is =

WACC = [ K_D * ( 1 – t ) * W_D ] + [ K_P * W_P ] + [ K_C * W_C ]

K_D = Required rate of return of debt    ; t = Income tax rate ; W_D  = Weight of debt ;

K_P = Required rate of return of Preferred Stock ; W_P = Weight of preferred stock    ;  

K_C = Required rate of return of Common Stock     ;   W_C  = Weight of common stock

As per the information available in the question we have

K_D = 4 %    ; t = 20 % = 0.2 ; W_D = 0.20 ; K_P = 6% ;   W_P = 0.30     ; K_C = 10%    ;   W_C = 0.50

Applying the above values in the formula we have

= [ ( 4 * ( 1 – 0.2 ) * 0.2 ) + ( 6 * 0.3 ) + ( 10 * 0.5 ) ]

= [ 0.64 + 1.8 + 5 ]

= 7.44

Thus the weighted average cost of capital of the Reactive power generation is 7.44 %