Question

Our firm's capital structure based on book values is 45% debt, 5% preferred stock and 50% equity. The firm's before tax cost of debt is 8%, its cost of preferred stock is 9%, its cost of equity is 12%, and its tax rate is 40%. Currently, the market value of debt is $300 million, the market value of preferred stock is $100 million, and the market value of equity is $600 million. What would be the firm's weighted average cost of capital (WACC) based on this information? 8.61% 10.50% 10.05% 9.54% 9.67%

Answer 1

Answer: The correct answer is 9.54%

Value of Preferred Stock = $100,000,000

Value of Debt = $300,000,000

Value of Common Stock = $600,000,000

Value of Firm = Value of debt + Value of Preferred Stock + Value of Common Stock
Value of Firm = $300,000,000 + $100,000,000 + $600,000,000
Value of Firm = $1,000,000,000

Weight of Debt = Value of Debt / Value of Firm
Weight of Debt = $300,000,000 / $1,000,000,000
Weight of Debt = 0.3

Weight of Preferred Stock = Value of Preferred Stock / Value of Firm
Weight of Preferred Stock = $100,000,000 / $1,000,000,000
Weight of Preferred Stock = 0.1

Weight of Common Stock = Value of Common Sock / Value of Firm
Weight of Common Stock = $600,000,000 / $1,000,000,000
Weight of Common Stock = 0.6

Before Cost of Debt = 8%

After Cost of Debt = Before Cost of Debt * (1-tax rate)
After Cost of Debt = 8% * (1-0.40)
After Cost of Debt = 4.8%

Cost of Preferred Stock = 9%

Cost of Common Stock = 12%

WACC = Weight of Debt * After Cost of Debt + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock
WACC = 0.3 *4.8% + 0.1*9% + 0.6 *12%
WACC = 9.54%