Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 25% weight in equity, 10% in preferred stock, and 65% in debt. The cost of equity capital is 13%, the cost of preferred stock is 9%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%

The WACC is 7.27%.

Explanation:

Debt is a tax-allowable expense. The use of Debt in capital structure reduces Taxable Profit and hence the Tax Paid to Revenue Authorities. In this case, the Lenders ask for 8% of return. The company will surely pay them 8% of amount borrowed. But the same Interest Expense will be deducted to calculate Taxable Profit and hence will provide a Tax Shield. This tax shield must be removed from the Cost of Debt. So, it is to remember that the cost of debt in WACC is always the cost of debt after tax and the formula for it is;

            Cost of Debt After Tax = Cost of Debt Before Tax * (1 - Tax Rate)

The above explained point is the only trick in this question, rest you have to simply make putting in the WACC formula which is;

WACC = (Cost of Equity * Weightage of Equity) + (Cost of Preferred Stock *   Weightage of Preffered) + (Cost of Debt After Tax * Weightage of Debt)

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