a company has determined that its opitmal capital structure consists of 40 percent debt and 60 percent equity. given the following information, calculate the firms weigted average cost of capital
rd=6%
tax rate=40%
p0=$25
growth=0%
do=$2.00
To calculate the firm's weighted average cost of capital (WACC), you need to consider the respective weights of debt and equity, as well as their respective costs. Here are the steps to calculate the WACC:
Step 1: Determine the cost of debt (rd).
In this case, the cost of debt is given as 6%. However, for the WACC calculation, we need to adjust the cost of debt by considering the tax shield provided by interest payments.
(Note: Interest payments are tax-deductible, which reduces the after-tax cost of debt for companies.)
To calculate the after-tax cost of debt (rd * (1 - tax rate)):
rd * (1 - tax rate) = 6% * (1 - 40%) = 6% * 60% = 3.6%
Step 2: Determine the cost of equity (re).
The cost of equity (re) can be calculated using the dividend discount model (DDM). The DDM formula is as follows:
re = (Dividend per share / Price per share) + Growth rate
Given:
Dividend per share (do) = $2.00
Price per share (p0) = $25
Growth rate (g) = 0%
Substituting the values:
re = ($2.00 / $25) + 0% = 0.08 + 0%
The cost of equity (re) is 8%.
Step 3: Calculate the weighted average cost of capital (WACC).
The WACC is calculated using the following formula:
WACC = (Weight of Debt * Cost of Debt) + (Weight of Equity * Cost of Equity)
Given:
Weight of Debt = 40% = 0.4
Weight of Equity = 60% = 0.6
Substituting the values:
WACC = (0.4 * 3.6%) + (0.6 * 8%)
Now, solve the equation to get the final result:
WACC = 1.44% + 4.8%
WACC = 6.24%
Therefore, the firm's weighted average cost of capital (WACC) is 6.24%.