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The market value of DEF Company's equity is $15 million and the market value of its...

The market value of DEF Company's equity is $15 million and the market value of its debt is $5 million. The required rate of return on its equity is 20% and 8% on its debt, Calculate the company's cost of capital if its tax rate is 25%

a. 20 percent

b. 16.5 percent

c. 14.5 percent

d. 17 percent

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Answer #1

Answer: The correct answer is b i.e. 16.5%

Market Value of Firm = Value of Equity + Value of Debt
Market Value of Firm = $15,000,000 + $5,000,000
Market Value of Firm = $20,000,000

Weight of Equity = Value of equity / Market Value of Firm
Weight of Equity = $15,000,000 / $20,000,000
Weigh of Equity = 0.75

Weight of Debt = Value of Debt / Market Value of Debt
Weight of Debt = $5,000,000 / $20,000,000
Weight of Debt = 0.25

After Cost of Debt = Cost of Debt * (1-tax rate)
After Cost of Debt = 8% * (1 – 0.25)
After Cost of Debt = 6%

WACC = Weight of Equity * Cost of Equity + Weight of Debt * After Cost of Debt
WACC = 0.75 * 20% + 0.25 * 6%
WACC = 16.5%

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