A firm's target capital structure consists of 40 percent debt, 5 percent preferred stock, and 55 percent common equity. The firm’s cost of debt is 10%, the cost of preferred stock is 11.26%, and the cost of equity is 14 %. What is the firm's weighted average cost of capital if the company tax rate is 35%?
To calculate the weighted average cost of capital (WACC) for a firm, you need to take into account the individual costs of each component of capital (debt, preferred stock, and equity), as well as the weight of each component in the firm's capital structure. Here's how you can calculate the WACC:
Step 1: Calculate the after-tax cost of debt.
The after-tax cost of debt takes into account the tax shield provided by the interest expense deduction. Use the formula: Cost of Debt * (1 - Tax Rate) to calculate it.
In this case, the cost of debt is given as 10%, and the tax rate is 35%. Therefore, the after-tax cost of debt would be: 10% * (1 - 0.35) = 6.5%.
Step 2: Calculate the weighted cost of each component.
Multiply the cost of each component by its respective weight in the firm's capital structure. In this case, the weights are given as 40% for debt, 5% for preferred stock, and 55% for common equity.
For the debt component: 6.5% * 40% = 2.6%
For the preferred stock component: 11.26% * 5% = 0.563%
For the equity component: 14% * 55% = 7.7%
Step 3: Sum up the weighted costs of each component.
Add up the weighted costs of each component to calculate the WACC.
WACC = Weighted cost of debt + Weighted cost of preferred stock + Weighted cost of equity
WACC = 2.6% + 0.563% + 7.7%
Step 4: Calculate the WACC.
WACC = 10.863%
Therefore, the firm's weighted average cost of capital (WACC), considering a company tax rate of 35%, is 10.863%.