Life Balance, Inc. has found that its cost of common equity capital is 15 percent and its cost of debt capital is 9 percent. If the firm is financed with $6 million of common shares (market value) and $4 million of debt, what is the after tax weighted average cost of capital (WACC) for the company if it is subject to a 30 percent marginal tax rate?

Question

Life Balance, Inc. has found that its cost of common equity capital is 15 percent and its cost of debt capital is 9 percent. If the firm is financed with $6 million of common shares (market value) and $4 million of debt, what is the after tax weighted average cost of capital (WACC) for the company if it is subject to a 30 percent marginal tax rate?

Answer 1

To calculate the after-tax weighted average cost of capital (WACC) for the company, you need to consider the proportions of both equity and debt in the company's capital structure, as well as the respective costs of equity and debt. From the given information, we know that the cost of common equity capital (Ke) is 15 percent, the cost of debt capital (Kd) is 9 percent, and the marginal tax rate (T) is 30 percent.

Step 1: Calculate the after-tax cost of debt (Kd(1-T)):
The after-tax cost of debt takes into account the tax advantage of interest payments. Multiply the cost of debt (Kd) by one minus the tax rate (T):
After-tax cost of debt (Kd(1-T)) = 0.09 * (1-0.30) = 0.09 * 0.70 = 0.063 or 6.3%

Step 2: Calculate the proportion of equity (E) in the capital structure:
The proportion of equity can be calculated by dividing the market value of equity shares by the total capital structure:
Proportion of equity (E) = Market value of equity shares / Total capital structure
E = $6 million / ($6 million + $4 million) = $6 million / $10 million = 0.6 or 60%

Step 3: Calculate the proportion of debt (D) in the capital structure:
The proportion of debt can be calculated by dividing the market value of debt by the total capital structure:
Proportion of debt (D) = Market value of debt / Total capital structure
D = $4 million / ($6 million + $4 million) = $4 million / $10 million = 0.4 or 40%

Step 4: Calculate the after-tax weighted average cost of capital (WACC):
The WACC is the weighted average of the after-tax cost of debt and the cost of equity, where the weights are the proportions of debt and equity in the capital structure:
WACC = (Proportion of equity * Cost of equity) + (Proportion of debt * After-tax cost of debt)
WACC = (0.6 * 0.15) + (0.4 * 0.063)
WACC = 0.09 + 0.0252
WACC = 0.1152 or 11.52%

Therefore, the after-tax weighted average cost of capital (WACC) for Life Balance, Inc. is 11.52%.