What is the weighted average cost of capital for a firm which has a debt-to-equi

Question

What is the weighted average cost of capital for a firm which has a debt-to-equity ratio of 74 and a beta of 2.2. The risk free rate is 5% and the market risk premium is 8.00%; the tax rate is your age (i.e. my tax rate is 55%) 3. 4. Using the value calculated in Problem 3, determine if the following is a good idea Your company has an existing manufacturing program for a stable product line (reference and complete the Excel file called Exam 2-Problem 4) The process is relatively stable but you think there is room for improvement. Based on what you have leamed from the gifted faculty at UMASS Lowell, you boldly state that, for $1,200,000 in capital equipment plus another $200,000 for R&D;, you could improve 2 process steps 15% each (you choose which ones) and that this would recover the capital equipment expense in less than 12 months. Is this possible? The expected monthly volumes are.: Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 Month 8 Month 9 Month 10 Month 11 Month 12 11,000 12,000 14,000 13,000 14,000 12,000 14,000 11,000 12,000 13,000 13,000 15,000 You will finance everything except R&D;, which has is own internal funding. Your company's policy for profit is 44% on sell price. What are you going to recommend? Depending on your results, are there any other alternatives for you to consider? Provide a comprehensive solution to prove or disprove your assertion. I expect to see calculations .....meaning ones relevant to what you have been learning lately Answers without showing how you got them will not be counted. Here's some more information and advice which you may find useful: Financing rate is 9.0%; you will be financing over 12 months for simplicity Manufacturing equipment such as what you are recommending, typically has a useful life of 5 years . Depreciate to zero Be thorough and make sure that you have considered all factors and have listed and supported all decisions and assumptions used in your calculations . . From there to here, from here to there, funny things are everywhere (Dr. Seuss)

Explanation / Answer

Solution:

First step: Compute cost of equity capital by using capital assets pricing model as follows:
=rf +flx(r.—rf) =5%+2.12x8% =21.96%
Hence, cost of equity is 21.96%.
Assumption
The before tax cost of debt is 15%.
Second step: Compute after tax cost of debt as follows:
After tax cost of debt =(1—tax)x before tax cost of debt
=(1-032) x15%
=10.20%.
Hence, after tax cost of debt is 10.20%.
Finally, compute weighted average cost of capital as follows:
WACC=(weight of debt xafter taxcost of debt)+(weight of eqtrityxcost of equity)
=1[94x0.1020)+(   x0.2196)
= 0.070615+0.067569 =0.138184
Thus, weighted average cost of capital 113.82%.1

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