You would like to estimate the weighted average cost of capital for a new airlin

Question

You would like to estimate the weighted average cost of capital for a new airline business. Based on its industry asset beta, you have already estimated an unlevered cost of capital for the firm of 8 %. However, the new business will be 27 % debt financed, and you anticipate its debt cost of capital will be 7%. If its corporate tax rate is 40%,what is your estimate of its WACC? The equity cost of capital is nothing %. (Round to one decimal place.) The weighted average cost of capital is: (Round to one decimal place.)

Explanation / Answer

ANSWER:

Given information,

Cost of equity or Un levered cost of capital of the firm = 8%,

Cost of debt = 7(1-0.40) = 4.2%,

Proportions:

Debt financed = 27%, = 0.27,

Equity = [100% - 27%] = 73% = 0.73.

Calculation of cost of weighted average cost of capital

S.No.

Sources

Cost of capital %

Proportion

WACC %

1

Equity (Ke)

8

0.73

5.84

2

Debt (After tax) (Kd)

4.2

0.27

1.134

3

WACC

6.97

Calculation of cost of weighted average cost of capital

Sl.NO.

Sources

Cost of capital %

Proportion

WACC %

1

Equity    (Ke)

0

0.73

0

2

Debt (After tax) (Kd)

4.2

0.27

1.134

3

WACC

1.13

NOTE: Equity cost of capital is nothing, i.e. as said in the problem

           Hence cost of equity (Ke)= 0   (I.e. Nothing)

S.No.

Sources

Cost of capital %

Proportion

WACC %

1

Equity (Ke)

8

0.73

5.84

2

Debt (After tax) (Kd)

4.2

0.27

1.134

3

WACC

6.97

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