Question

1. The target capital structure for a firm is 40% common stock, 10% preferred stock and 50% debt. If the cost of common equity is 18%, the cost of preferred stock is 10%, the before-tax cost of debt is 8%, and the firm’s tax rate is 35%. What is its weighted average cost of capital?

Indicate the detailed steps on how to use a FINANCIAL CALCULATOR to solve the problems.

Answer 1

Information provided:

Weight of debt in the capital structure= 50%

Weight of equity in the capital structure= 40%

Weight of preferred stock in the capital structure= 10%

Cost of common equity= 18%

Before tax cost of debt= 8%

Cost of preferred stock= 10%

Tax rate= 35%

The weighted average cost of capital is calculated using the below formula:

WACC=Wd*Kd(1-t)+Wps*Kps+We*Ke

where:

Wd= Percentage of debt in the capital structure.

Kd= The before tax cost of debt

Wps= Percentage of preferred stock in the capital structure

Kps=Cost of preferred stock

We=Percentage of equity in the capital structure

Ke= The cost of common equity.

T= Tax rate

WACC= 0.50*8%*(1 – 0.35) + 0.10*10% + 0.40*18%

            = 2.60% + 1% + 7.20%

            = 10.80%.

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