To calculate the firm's Weighted Average Cost of Capital (WACC), we need to consider how much of the firm is financed by debt and equity, the cost of each, and the tax benefit of using debt.
Step 1: Identify the information given.
- Debt-to-asset ratio = 35% = 0.35
- Cost of debt = 3.55% = 0.0355
- Cost of equity = 8.65% = 0.0865
- Marginal tax rate = 34% = 0.34
Step 2: Find the equity-to-asset ratio.
A firm's financing comes from debt and equity. Since 35% of the firm's assets are financed by debt, the remaining 65% must be financed by equity.
Equity ratio = 100% - 35% = 65%
Equity ratio = 0.65
Step 3: Write the WACC formula.
WACC = (Equity Weight × Cost of Equity) + (Debt Weight × Cost of Debt × (1 - Tax Rate))
The reason we multiply the cost of debt by (1 - Tax Rate) is that interest expenses are generally tax-deductible, which reduces the effective cost of borrowing.
Step 4: Substitute the values.
WACC = (0.65 × 0.0865) + (0.35 × 0.0355 × (1 - 0.34))
First, calculate the equity portion:
0.65 × 0.0865 = 0.056225
Next, calculate the after-tax debt portion:
1 - 0.34 = 0.66
0.35 × 0.0355 × 0.66 = 0.0082005
Step 5: Add the two portions together.
WACC = 0.056225 + 0.0082005
WACC = 0.0644255
Convert to a percentage:
0.0644255 × 100 = 6.44255%
Final Answer: WACC = 6.44%
Why does this make sense?
The firm uses two sources of financing: debt and equity. Equity is more expensive at 8.65%, while debt costs only 3.55% before taxes. Because interest payments provide a tax benefit, the effective cost of debt is even lower.
By weighting each financing source according to its share of the firm's total market value, we find that the firm's overall cost of capital is approximately 6.44%.
This means the firm generally needs to earn about 6.44% on investments with risk similar to its existing operations to cover the required returns of its investors and lenders.
