A firm has capital structure containing 60% debt and 40% common stock equity. It

Question

A firm has capital structure containing 60% debt and 40% common stock equity. Its outstanding bonds offer investors as 6.5% yield to maturity. The risk-free rate currently equals 5%, and the expected risk premium on the market portfolio equals 6%. The firm's common stock beta is 1.20.

a) What is the firm's required return on equity?

b)Ignoring taxes, use your finding in part (a) to calculate the firm's WACC.

c)Assuming a 40% tax rate, recaluculate the firm's WACC found in part (b).

d)Compare and contrast the values for the firm's WACC found in parts (b) and (c).

Explanation / Answer

a. required return on equity = risk free rate+beta*risk premium

= 5%+1.2*5%

=11%

b. WACC = weight of debt*cost of debt+weight of equity*cost of equity

= 60%*6.5%+40%*11%

=8.3%

c. WACC = weight of debt*cost of debt*(1-t)+weight of equity*cost of equity

=60%*6.5%*(1-40%)+40%*11%

=6.74%

c. The WACC of the company reduced due to the tax rate. As your corporate income tax rate goes up, your company's WACC goes down since a higher rate produces a larger tax shield.

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