Question

Problem 9 You are given the following information about a firm and the equity-debt structure of this firm: i) The amount of long-term outstanding debt is 150,000. ii) The debt is risk-free and is financed at an interest rate of 7%. iii) Number of shares of common stock is 40,000. iv) The price per share is 15. v) The stock's beta is 1.2. vi) The expected market return is 14%. Calculate the firm's before-tax cost of capital.

Answer 1

Calculating Firms Before Tax Cost of Capital

If the company has used different methods of financing, then the cost of capital is calculated by the weighted average cost of capital.

The method for calculating WACC is often expressed in the following formula:

WACC = percentage of financing that is equity * cost of equity + percentage of financing that is debt * cost of Debt

Percentage of financing that is equity = market value of the firm’s equity / total market value of the firm’s financing (equity and debt)

=40000*15/(40000*15+150000)

= .8

Cost Of Equity = Re=Rf+Beta(Rm-Rf)

Rf = Risk Free Return =7%

Beta =1.2

Rm = MArket Return =14%

Re =7+1.2(14-7)

=15.4%

Percentage of financing Debt = market value of the firm’s Debt / total market value of the firm’s financing (equity and debt)

=150000/(40000*15+150000)

=.2

Cost of Debt = 7%

Answer :

WACC =.8*15.4 + .2*7

=13.72%