Question

Baron Corporation has a target capital structure of 70 percent common stock, 5 percent preferred stock, and 25 percent debt. Its cost of equity is 10 percent, the cost of preferred stock is 6 percent, and the pretax cost of debt is 7 percent. The relevant tax rate is 22 percent. a. What is the company’s WACC?

Answer 1

Solution:

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 ]

where

K_D = Pre tax Cost of debt    ; t = Income tax rate ; W_D = Weight of debt ;

K_P = Cost of Preferred Stock ; W_P = Weight of preferred stock    ;  

K_C = Cost of Common Stock     ;    W_C = Weight of common stock

As per the information available in the question we have

K_D = 7 %     ; t = 22 % = 0.22 ; W_D = 25% = 0.25 ;

K_P = 6 % ;    W_P = 5 % = 0.05     ;

K_C = 10 %    ;    W_C = 70 % = 0.70

Applying the above values in the formula we have

= [ ( 7 * ( 1 – 0.22 ) * 0.25 ) + ( 6 * 0.05 ) + ( 10 * 0.7 ) ]

= [ ( 7 * 0.78 * 0.25 ) + 0.3 + 7 ]

= [ 1.365 + 0.3 + 7 ]

= 8.665 %

= 8.67 % ( When rounded off to two decimal places )

Thus the weighted average cost of capital is 8.67 %