Taxes and WACC. Rainbow in the Dark Manufacturing has a target debt-equity ratio of .65. Its cost of equity is 13%, and its cost of debt is 8%. If the tax rate is 35%, what is the company's WACC?
To calculate the Weighted Average Cost of Capital (WACC) for Rainbow in the Dark Manufacturing, we need to combine the cost of equity and the cost of debt, taking into account their respective weights in the company's capital structure.
Here's how you can calculate the WACC step by step:
1. Start with the given information:
- Cost of equity (Ke) = 13%
- Cost of debt (Kd) = 8%
- Debt-equity ratio = 0.65
- Tax rate (T) = 35%
2. Calculate the weight of equity (We) and the weight of debt (Wd) in the company's capital structure:
- Weight of equity (We) = 1 - debt-equity ratio = 1 - 0.65 = 0.35
- Weight of debt (Wd) = debt-equity ratio = 0.65
3. Calculate the after-tax cost of debt (Kd*(1-T)):
- After-tax cost of debt = Kd*(1-T) = 8% * (1 - 35%) = 5.2%
4. Calculate the WACC using the formula:
WACC = (We * Ke) + (Wd * (Kd*(1-T)))
Substitute the values into the formula:
WACC = (0.35 * 13%) + (0.65 * 5.2%)
WACC = 0.0455 + 0.338
WACC ≈ 0.3835 or 38.35%
Therefore, Rainbow in the Dark Manufacturing has a WACC of approximately 38.35%.
To calculate the weighted average cost of capital (WACC) for Rainbow in the Dark Manufacturing, we need to take into account the target debt-equity ratio, the cost of equity, cost of debt, and the tax rate.
1. Calculate the weight of equity: Since the target debt-equity ratio is 0.65, the weight of equity is 1 - 0.65 = 0.35.
2. Calculate the weight of debt: Since the target debt-equity ratio is 0.65, the weight of debt is 0.65.
3. Calculate the after-tax cost of debt: The cost of debt is 8%, and the tax rate is 35%. To calculate the after-tax cost of debt, we multiply the cost of debt by 1 minus the tax rate:
After-tax cost of debt = 8% * (1 - 0.35) = 8% * 0.65 = 5.2%.
4. Calculate the WACC: The WACC is the weighted average of the cost of equity and the after-tax cost of debt.
WACC = (Weight of equity * Cost of equity) + (Weight of debt * After-tax cost of debt)
WACC = (0.35 * 13%) + (0.65 * 5.2%)
WACC = 4.55% + 3.38%
WACC = 7.93%
Therefore, the company's WACC is 7.93%.
(1/1.65) x .13 + (.65/1.65) x .08 x .65
= .099273
= 9.93%