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Jack's Construction Co. has $80 million in outstanding debt. The debt has a yield to maturity...

Jack's Construction Co. has $80 million in outstanding debt. The debt has a yield to maturity of 8.5%. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4% and the market risk premium is 8%. Jack's tax rate is 35%. What is Jack's weighted average cost of capital?

7.10%

7.39%

11.37%

10.65%

10.38%

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Answer #1

Answer: The correct answer is 10.38%

Value of Debt = $80,000,000

Value of Equity = 4,000,000 shares * $40
Value of Equity = $160,000,000

Total Value of Firm = Value of Debt + Value of Equity
Total Value of Firm = $80,000,000 + $160,000,000
Total Value of Firm = $240,000,000

Weight of Debt = Value of Debt / Total Value of Firm
Weight of Debt = $80,000,000 / $240,000,000
Weight of Debt = 0.3333

Weight of Equity = Value of Equity / Total Value of Firm
Weight of Equity = $160,000,000 / $240,000,000
Weight of Equity = 0.6667

Cost of Debt after tax = Cost of Debt * (1 – tax rate)
Cost of Debt after tax = 8.5% * (1- 0.35)
Cost of Debt after tax = 8.5% * 0.65
Cost of Debt after tax = 5.53%

Cost of Equity = risk free rate + Beta * Market Risk Premium
Cost of Equity = 0.04 + 1.1 * 0.08
Cost of Equity = 0.04 + 0.088
Cost of Equity = 0.128 or 12.8%

Weighted Average Cost of Capital = Cost of Debt * Weight of Debt + Cost of Equity * Weight of Equity
Weighted Average Cost of Capital = 5.53% * 0.3333 + 12.8% * 0.6667
Weighted Average Cost of Capital = 1.84% + 8.54%
Weighted Average Cost of Capital = 10.38%

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