Suppose a company is valued by the market at $60 million and is financed with both debt and equity. Currently, the company has a market value of equity of $10 million. The company also has a market value of short-term debt of $15 million and a market value of long-term debt of $35 million. The cost of equity is 17%, the cost of short-term debt is 9% and the cost of long-term debt is 11%. If the marginal tax rate is 34%, what is the weighted average cost of capital?

WACC = 8.6%

Explanation:

The WACC is the average cost of all the sources of finance used by a company  weihhed according to the proportion that the market value of each bears to the the total market value the entire pool.

So we work out the WACC of the company as follows:

Step 1

Compute the cost of the individual sources of finance

Short term debt

9% × (1-0.34)= 6%

Long term debt

11% ×  (1-0.34) = 7%

Equity - 17%

Step 2

Calculate the WACC

Source                           Cost (C)    M Value  (MV)  C × MV

Short term debt             6%                $15              0.891

Long term debt              7%                $35             2.541

Equity                              17%               $10             1.7

                                                               50           5.132

WACC =   (5.132/50) × 100

          =   8.6%

WACC = 8.6%

WACC  is 8.33%

Explanation:

WACC=(  V/ E ×Re)+(   D/V ×Rd×(1−Tc))

where:

E=Market value of the firm’s equity =$10 million

D=Market value of the firm’s debt =$35 million+$15 million=$50 million

V=E+D =$10million+$50 million=$60 million

Re=Cost of equity =17%

Rd=Cost of debt =(9%+11%)/2=10%

Tc=Corporate tax rate =34%

WACC=(10/60*17%)+(50/60*10%*(1-0.34)

WACC=2.83% +5.50%

WACC=8.33%

The weighted average cost of capital is the average overall cost of capital of the company having considered both equity cost as well as debt cost .

Note that the ore-tax cost of debt was by averaging the cost of short term and long-term debt

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