A firm has determined its target capital structure as having 52% of its assets financed with debt and the remaining with equity. However, the debt is split evenly between a bank term loan bearing an interest cost of 8.8% and bonds that have a yield to maturity of 9.4%. If shareholders in the firm demand a 15.1% return on their investment and the tax rate is 30% what is the firm's cost of capital? Please type your answer in decimals rounded to three decimal places. (eg. 9.79% should be shown as 0.098 )
Question
A firm has determined its target capital structure as having 52% of its assets financed with debt and the remaining with equity. However, the debt is split evenly between a bank term loan bearing an interest cost of 8.8% and bonds that have a yield to maturity of 9.4%. If shareholders in the firm demand a 15.1% return on their investment and the tax rate is 30% what is the firm's cost of capital? Please type your answer in decimals rounded to three decimal places. (eg. 9.79% should be shown as 0.098 )
Solution
The firm's cost of capital, also known as the Weighted Average Cost of Capital (WACC), is calculated by multiplying the cost of each capital component by its proportional weight and then summing.
Here's how to calculate it:
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First, calculate the after-tax cost of debt. The interest on debt is tax-deductible, so the after-tax cost of debt is the pre-tax cost of debt multiplied by (1 - tax rate).
For the bank term loan: 8.8% * (1 - 0.30) = 0.0616 or 6.16%
For the bonds: 9.4% * (1 - 0.30) = 0.0658 or 6.58%
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Since the debt is split evenly between the bank term loan and the bonds, the weight of each type of debt in the capital structure is 52% / 2 = 26%.
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Next, calculate the weighted cost of each type of capital.
For the bank term loan: 0.0616 * 0.26 = 0.016016
For the bonds: 0.0658 * 0.26 = 0.017108
For equity: 0.151 * 0.48 = 0.07248 (since 100% - 52% = 48% of the capital structure is equity)
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Finally, sum up these weighted costs to get the WACC:
WACC = 0.016016 + 0.017108 + 0.07248 = 0.105604 or 10.560%
So, the firm's cost of capital is 0.106 when rounded to three decimal places.
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