You were hired as a consultant to ABC Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The before-tax cost of debt is 8.00%, the cost of preferred is 7.50%, and the cost of common is 12.75%. What is its WACC if the tax rate is 25%?
To calculate the Weighted Average Cost of Capital (WACC), we first need to understand the different components of the company's capital structure and their respective costs.
1. Debt: The company has a target debt of 40% in its capital structure, and the before-tax cost of debt is 8.00%. However, since the tax rate is given as 25%, we need to calculate the after-tax cost of debt. The formula for after-tax cost of debt is:
After-tax cost of debt = Before-tax cost of debt * (1 - Tax rate)
After-tax cost of debt = 8.00% * (1 - 0.25) = 8.00% * 0.75 = 6.00%
2. Preferred Stock: The company has a target preferred stock of 15% in its capital structure, and the cost of preferred stock is 7.50%.
3. Common Equity: The company has a target common equity of 45% in its capital structure, and the cost of common equity is 12.75%.
Now, we can calculate the WACC using the following formula:
WACC = (Weight of Debt * After-tax cost of debt) + (Weight of Preferred Stock * Cost of preferred stock) + (Weight of Common Equity * Cost of common equity)
WACC = (0.40 * 6.00%) + (0.15 * 7.50%) + (0.45 * 12.75%)
WACC = 2.40% + 1.125% + 5.7375% = 9.2625%
Therefore, the WACC for ABC Company, with a tax rate of 25%, is 9.2625%.