A company has a target capital structure of 40% debt and 60% equity. The cost of equity is 12%, and the pre-tax cost of debt is 6%. The corporate tax rate is 25%. What is the Weighted Average Cost of Capital (WACC)?

Answer options:

9.6%

9.0%

8.4%

7.2%

How to approach this question

WACC = (Weight Equity × Cost Equity) + (Weight Debt × Cost Debt × (1 - Tax Rate)). Remember debt interest is tax-deductible.

Full Answer

B.9.0%✓ Correct

After-tax cost of debt = 6% × (1 - 0.25) = 4.5%. Weighted cost of debt = 40% × 4.5% = 1.8%. Weighted cost of equity = 60% × 12% = 7.2%. WACC = 1.8% + 7.2% = 9.0%.

Common mistakes

Using pre-tax cost of debt; swapping weights.

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