A company wishes to explore the effect on its cost of capital of the rate at whi

Question

A company wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. the firms wishes to maintain a capital structure of 25% debt, 15% preferred stock, and 60% common stock. The cost of financing with retained earnings is 11%, the cost of preferred stock financing is 9%, and the before-tax cost of debt financing is 9%. Calculate the weighted average cost of capital (WACC) given a tax rate of 40%. Can someone please explain me how to solve this problem step by step.

Explanation / Answer

Step-1:

Weighted average cost of capital (WACC)=

Cost of common stock*weight of common stock in Capital Structure

+ Cost of preferred stock*weight of preferred stock in capital structure

+Cost debt (1-tax)* Weight of debt in Capital Structure

=11*.6+9*.15+5.4*.25

=6.6+1.35+1.35

=9.3%

Step-2:

Cost of debt after tax=9%(1-.4)=5.4%

Thus, weighted average cost of capital is 9.3%

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