Practice Problem – WACC

Practice Question

Intro to Finance
Weighted Average Cost of Capital (WACC)
Debt-to-Equity
Short Answer

A firm's market values of debt and equity are $200,000 and $500,000, respectively. The before-tax cost of debt = 5%; Rf = 3%; beta = 1.06; the market risk premium = 8%; and the tax rate = 25%. What is WACC?

Answer +
9.3%
Explanation +

Step 1: Calculate total value (V)
V = 200,000 (Debt) + 500,000 (Equity) = 700,000

Step 2: Proportions
D/V = 200,000 / 700,000 = 0.2857
E/V = 500,000 / 700,000 = 0.7143

Step 3: Cost of Equity (Ke)
Using CAPM: Ke = Rf + β × (Market Risk Premium) = 3% + 1.06 × 8% = 11.48%

Step 4: After-tax Cost of Debt (Kd)
Kd × (1 – Tax Rate) = 5% × 0.75 = 3.75%

Step 5: WACC formula
WACC = (E/V × Ke) + (D/V × Kd × (1 – T))
WACC = (0.7143 × 11.48%) + (0.2857 × 3.75%) = 8.2% + 1.07% = 9.27%

The final WACC is approximately 9.3%.