CF 11-5A – WACC – Corporate Finance

Let's run through 11.5a. It says the company's target capital structure consists of 60% debt, 30% common shares, and 10% preferred shares. Some facts are below. Our cost of debt, 12%, common equity, 18%, preferred equity, 10%, and the tax rate is 25%, meaning our cost of debt isn't 12. Well, our pre-tax cost of debt is 12. What's our after-tax cost of debt? We multiply that by 1 minus the tax rate. So I'm going to multiply that by 75%. 12 times 0.75 is 9. And now I just apply the weights. I go, okay, well, debt is 60% of my portfolio. It's 9%. So let's do a weighted average here. These weights have to add up to 100, 18 times 30%, and 10 times 10%. Let's crunch those numbers. 9 times 60%. What is that? 65.4 times 0.09, 5.4. I always get it as I'm like putting it in the calculator. 18 times 30, also 5.4? That would be weird. I should change the numbers next time I revise this. 18 times 0.3. Yeah, also 5.4 in a strange coincidence. 10 times 10, not 5.4, it's 1. Okay, so there we have it. Add them up, 10, 11. It's 11.8%. That's our weighted average cost of capital. That number is the number the company ought to be using when it does, you know, it's looking at a project and it has to compute its required rate of return. You know, that number that we've taken as given the whole course? Well, this is how the company figures out the number, and we've figured out how to do cost of debt and cost of equity in previous questions. So you just figure out, well, this is my capital structure, desired capital structure. And this is what the weighted average cost of capital is at that structure. And now when I think about future projects, my required rate of return for this company is going to be like 12%, 11.8%. So there you have it. One other thing students sometimes wonder is they go, well, that's 9%. It's cheap, right? Equity is like 30. Why don't we just go like all in on debt? And the answer is, because as that changes, your risk levels change, right? If you go all in on debt, you're so highly leveraged, nobody's going to lend to you at this 12% slash 9% after tax. So it change a variable significantly, and it can throw the whole thing out of whack. And, you know, your bankruptcy risk is just through the roof. If it's almost always debt, debt is cheap. So like, almost always, it would be like, well, why don't we just take on more debt? And the answer is because your cost of debt will go up as you take on more debt. Anyway, there we have it. We've solved 11.5a. Hopefully it doesn't cost you much to smash one of those buttons. Thanks for watching. Goodbye.