Question

9 Company A has a capital structure as shown below. Calculate its weighted average cost of capital. Debt (after tax Preferred Stock Common Stock K 13.00% 8.50% 6.00% Dollars 400,000 100,000 500,000 1,000,000 a b с 6.99% 7.25% 8.55% 9.05% none of the above. d 10 1 Afirm uses debt, and borrows at 6.35%. Its marginal tax rate is 33%. Calculate the after tax component cost of debt 4.25% 4.50% 4.97% 8.00% OP

Answer 1

1. Option (d) is correct

In the first step, we will calculate the weight of debt, preferred stock and common stock.by dividing the amount invested in each stock by the total amount the amount invested in the fund i.e. $1000000.:

Debt (after tax): $400000 / $1000000 = 0.4

Preferred stock: $100000 / $1000000 = 0.1

Common stock: $500000 / $1000000 = 0.5

Now,

The formula for weighted average cost of capital is:

WACC = w_e * r_e + w_d* r_d * (1 - t) + w_p *r_p

where, w_e = Percentage of equity or common stock = 0.5

w_d = Percentage of debt = 0.4

w_p = Percentage of preferred stock = 0.1

r_e = Cost of equity = 6%

r_d * (1 - t) = After tax cost of debt = 13%

r_p = Cost of preferred stock = 8.5%

Now, putting these values in the WACC formula, we get,

WACC = ((0.5 * 6%) + (0.4 * 13%) + (0.1 * 8.5%))

WACC = 3% + 5.2% + 0.85% = 9.05%

2. Option (a) is correct

After tax cost of debt = Debt * ( 1 - tax rate)

After tax cost of debt = 6.35% * (1 - 0.33)

after tax cost of debt = 6.35% * 0.67 = 4.25%