A company’s balance sheets show a total of $30 million long-term debt with a cou

Question

A company’s balance sheets show a total of $30 million long-term debt with a coupon rate of 9 percent. The yield to maturity on this debt is 11.11 percent, and the debt has a total current market value of $25 million. The balance sheets also show that that the company has 10 million shares of stock; the total of common stock and retained earnings is $30 million. The current stock price is $7.5 per share. The current return required by stockholders, rS, is 12 percent. The company has a target capital structure of 40 percent debt and 60 percent equity. The tax rate is 40%. What weighted average cost of capital should you use to evaluate potential projects?

Explanation / Answer

AFTER TAX COST OF DEBT

= YTM * (1 - TAX RATE)

= 11.11 * (1 - 0.40)

= 6.67%

COST OF EQUITY = 12%

WEIGHTED AVERAGE COST OF CAPITAL

= 0.40 (6.67%) + 0.6 (12%)

= 9.87%

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