Series 79 practice questionmediumWACC and Cost of Capital
A company has a cost of equity of 12%, a pre-tax cost of debt of 6%, a tax rate of 25%, equity comprising 60% of capital, and debt comprising 40% of capital. What is the company's WACC?
- A9.0%✓ Correct answer
- B9.6%
- C7.2%
- D8.4%
Explanation
Why A — 9.0%
WACC = (E/V x Re) + (D/V x Rd x (1-T)) = (0.60 x 12%) + (0.40 x 6% x (1-0.25)) = 7.2% + 1.8% = 9.0%. The cost of debt is tax-adjusted because interest expense is tax-deductible, creating a tax shield that effectively reduces the cost of debt financing. This tax benefit is one reason why companies use debt in their capital structure, as it lowers the overall WACC relative to an all-equity financed firm.
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