A firm uses only debt and equity in its capital structure. The firm's weight of equity is 70 percent. The firm's cost of equity is 13 percent and it has a tax rate of 21 percent. If the firm's WACC is 11 percent, what is the firm's before-tax cost of debt?
A) 7.19 percent
B) 8.02 percent
C) 6.38 percent
D) 1.9 percent

Question

Quizplus · Accepted Answer

The Weighted Average Cost of Capital (WACC) is calculated as follows: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is the market value of the equity, D is the market value of the debt, V is the total market value of the firm's financing (E + D), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. Given that the weight of equity (E/V) is 70% or 0.7, the weight of debt (D/V) must be 30% or 0.3, the cost of equity (Re) is 13%, and the tax rate (Tc) is 21%. The WACC is given as 11%. Plugging the known values into the WACC formula gives: 11% = (0.7 * 13%) + (0.3 * Rd * (1 - 0.21)). Solving for Rd (the before-tax cost of debt) gives Rd = 8.02%.

A Firm Uses Only Debt and Equity in Its Capital