Practice Problem – WACC

Practice Question

WACC
Cost of Capital
Short Answer

Consider the following information to calculate a firm’s WACC:

- Debt-to-equity ratio: 1.2
- Before-tax cost of debt: 7%
- Risk-free rate: 3%
- Beta: 1.2
- Market return: 8%
- Tax rate: 40%

Answer +
Final Answer: The firm’s WACC is approximately 6.38%.
Explanation +

To calculate the Weighted Average Cost of Capital (WACC), we blend the cost of equity and after-tax cost of debt based on their respective weights in the capital structure.

1. Calculate the Cost of Equity (\(K_e\))

Using the Capital Asset Pricing Model (CAPM):
\[ K_e = R_f + \beta (R_m - R_f) \] \[ K_e = 0.03 + 1.2(0.08 - 0.03) = 0.03 + 0.06 = 0.09 \text{ or } 9\% \]

2. Calculate Capital Weights from D/E Ratio

Debt-to-equity ratio = 1.2 → D = 1.2, E = 1.0 ⇒ Total = 2.2
\[ W_d = \frac{1.2}{2.2} \approx 0.545, \quad W_e = \frac{1.0}{2.2} \approx 0.455 \]

3. Calculate After-Tax Cost of Debt

\[ K_d (1 - T) = 0.07 \times (1 - 0.40) = 0.07 \times 0.60 = 0.042 \text{ or } 4.2\% \]

4. Combine to Get WACC

\[ WACC = W_d \cdot K_d (1 - T) + W_e \cdot K_e \] \[ WACC = 0.545 \cdot 0.042 + 0.455 \cdot 0.09 = 0.02289 + 0.04095 = 0.06384 \] \[ \boxed{\text{WACC} \approx 6.38\%} \]

Conclusion

The firm’s WACC — its average financing cost for investments — is approximately 6.38%. This is a crucial hurdle rate for evaluating new projects or investment opportunities.