Central Systems has a pretax cost of debt of 8%, an average tax rate of 30%, and a cost of equity of 14%. If the company’s debt-equity mix is 50%-50%, what is Central’s weighted average cost of capital?
To find the weighted average cost of capital (WACC), we need to calculate the costs of equity and debt and then apply the appropriate weights.
1. Calculate the cost of debt after tax:
The cost of debt is given as 8%. Since the average tax rate is 30%, we need to calculate the after-tax cost of debt using the following formula:
Cost of Debt after Tax = Cost of Debt x (1 - Tax Rate)
Cost of Debt after Tax = 8% x (1 - 0.30)
Cost of Debt after Tax = 8% x 0.70
Cost of Debt after Tax = 5.6%
2. Calculate the cost of equity:
The cost of equity is given as 14%.
3. Determine the weight for each component:
Since the debt-equity mix is 50%-50%, we assign a weight of 50% to both the debt and equity.
4. Calculate the WACC:
WACC = (Weight of Debt x Cost of Debt after Tax) + (Weight of Equity x Cost of Equity)
WACC = (0.50 x 5.6%) + (0.50 x 14%)
WACC = 2.8% + 7%
WACC ≈ 9.8%
Therefore, Central Systems has a weighted average cost of capital (WACC) of approximately 9.8%.