The Nutrex Corporation wants to calculate its weighted average cost of capital.

Question

The Nutrex Corporation wants to calculate its weighted average cost of capital. Its target capital structure weights are 40 percent long term debt and 60 percent common equity. The before tax cost of debt is estimated to be 10 percent and the company is in the 40 percent tax bracket. The current risk free interest rate is 8 percent on Treasury bills. The expected return on the market is 13 percent and the firm's stock beta is 1.8.
a. What is Nutrex's cost of debt?
b. Estimate Nutrex's expected return on common equity using the security market line.
c. Calculate the after tax weighted average cost of capital.

Explanation / Answer

weight_d = 40% weight_e = 60% before tax cost of debt = 10% = 0.1 tax,t = 40% risk free rate = 8% beta = 1.8 market return = 13% = 0.13 cost of debt = (before tax cost of debt)*(1-t)*weight_d = 0.1*(1-0.4)*0.4 = 2.4% Nutrex expected return on common equity = risk free return + (beta)*(market return - risk free return) = 0.08 + 1.8(0.13-0.08) = 17% after-tax weighted average cost of capital. = cost of debt + (weight_e)*(expected return on equity ) = 0.024 + 0.6*0.17 = 12.6% weighted average cost of capital = 12.6%

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