Based On The Information Provided Below, Compute The Weighte

Based On The Information Provided Below Compute The Weighted Average

Based On The Information Provided Below Compute The Weighted Average Cost of Capital showing all steps take to arrive at the answer. (CO 7). Acme International Capital Sources Required Return rates Common Stock and Retained Earnings $ 400,000 8% Preferred Stock $ 100,000 7% Corporate Bonds $ 300,000 10% Corporate tax rate 35%

Paper For Above instruction

Introduction

The Weighted Average Cost of Capital (WACC) is a crucial financial metric used by firms to evaluate the cost of capital considering the proportional weights of each component in the firm's capital structure. It reflects the average rate of return that a company must pay to finance its assets through debt, preferred stock, and common equity. WACC is instrumental for decision-making processes such as investment appraisal, capital budgeting, and valuation, since it acts as a hurdle rate against which the potential profitability of projects is evaluated.

This paper aims to compute the WACC for Acme International based on provided capital structure data, required return rates, and applicable corporate tax rate, demonstrating detailed steps and calculations. The process involves calculating the market value weights for each component of capital, adjusting the cost of debt for tax effects, and aggregating these elements into the final WACC figure.

Components of Capital and Their Costs

The firm’s sources of capital include common stock with retained earnings, preferred stock, and corporate bonds. The respective amounts and required return rates are as follows:

- Common Stock and Retained Earnings: $400,000 at 8%

- Preferred Stock: $100,000 at 7%

- Corporate Bonds (Debt): $300,000 at 10%

The corporate tax rate is 35%, which affects the after-tax cost of debt.

Calculating the Total Market Value of Capital

The first step establishes the total value of capital contributions from all sources.

Total capital = $400,000 + $100,000 + $300,000 = $800,000

Next, calculate the proportions of each component relative to total capital:

- Weight of common stock = $400,000 / $800,000 = 0.5

- Weight of preferred stock = $100,000 / $800,000 = 0.125

- Weight of debt = $300,000 / $800,000 = 0.375

Calculating Cost Components

The costs associated with each source are given:

- Cost of common equity (Re) = 8%

- Cost of preferred stock (Rp) = 7%

- Cost of debt (Rd) = 10%

Debt costs must be adjusted for taxes because interest expense is tax-deductible:

- After-tax cost of debt = Rd (1 - Tax rate) = 10% (1 - 0.35) = 10% * 0.65 = 6.5%

Computing the WACC

Now, aggregate these components to compute the WACC:

WACC = (Weight of Equity Cost of Equity) + (Weight of Preferred Stock Cost of Preferred) + (Weight of Debt * After-tax Cost of Debt)

Plugging in the numbers:

WACC = (0.5 8%) + (0.125 7%) + (0.375 * 6.5%)

Calculations:

- Equity component = 0.5 * 0.08 = 0.04

- Preferred stock component = 0.125 * 0.07 = 0.00875

- Debt component = 0.375 * 0.065 = 0.024375

Summing these:

WACC = 0.04 + 0.00875 + 0.024375 = 0.073125 or 7.3125%

Conclusion

The weighted average cost of capital (WACC) for Acme International is approximately 7.31%. This rate represents the minimum return that the company's projects need to generate to satisfy its capital providers, accounting for the costs of equity, preferred stock, and debt, adjusted for tax advantages on interest expenses.

References

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