A firm uses only debt and equity in its capital structure. The firm's weight of equity is 35 percent. The firm's cost of equity is 14 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) 11.88 percent
B) 9.38 percent
C) 5.50 percent
D) −3.00 percent

Question

Quizplus · Accepted Answer

The firm's WACC (Weighted Average Cost of Capital) is calculated as follows: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is the market value of the firm's equity, D is the market value of the firm's debt, V = E + D (the total market value of the firm's financing), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. Given that the firm's weight of equity (E/V) is 35% or 0.35, the cost of equity (Re) is 14%, the tax rate (Tc) is 21%, and the WACC is 11%, we can rearrange the formula to solve for Rd, the before-tax cost of debt. Plugging in the given values and solving for Rd gives us a before-tax cost of debt of approximately 11.88%.

A Firm Uses Only Debt and Equity in Its Capital