ABC Company currently has a debt-to-equity ratio of 0.3. Its target debt-to-equity ratio is 0.4. The risk-free rate is 6%, and expected equity market return is 12%. ABC is considering a project that has a beta of 1.2. Given that the company’s after-tax cost of debt is 7%, and the applicable tax rate is 40%, the WACC that should be used in evaluating this project is closest to:

A. 10.63% B. 11.43% C. 11.77%

Answer: B

Cost of equity = 0.06 + 1.2 (0.12 – 0.06) = 13.2%

Using component weights in the target capital structure: WACC = [0.132 * (1/1.4)] + [0.07 * (0.4/1.4)] = 11.43%

Just wanted to confirm, but the reson that they didnt use (1-t) is because they gave us the after tax cost of debt right?


Why use target Debt to equity, when you have the current market values?

Not really sure. I just take it when they embark on the project that is the ratio they would like to obtain. At this point there are a lot of things I dont understand fully; I only understand the calculations. Really just trying to pass the test and understand it fully before level 2.

you want to use the target capital structure since that’s what the company is striving for; and yes they didn’t use 1-t because its after tax; the tax rate has already been accounted for

In order, use:

  • The target capital structure, if given
  • The existing capital structure, if it’s reasonable for the industry
  • The industry average capital structure

As mentioned, you use the factor (1 – t) to get from the before-tax cost of debt to the after-tax cost of debt. If you’re given the after-tax cost of debt, the (1 – t) is already in there.

Ok , So we have after tax cost of debt = 7%.

target Debt/equity = .4

Here we calculate the Waac= .2857(.07) + .7143(.132)

= .02 + .0943

= 11.43%(Ans)

How we have calculated the weights of Debt and Equity.

Weight of debt = .4/1.4 = .2857

weight of equity = 1/1.4 = .7143