Based On The Information Provided Below, Compute The 206443
Based On The Information Provided Below Compute The Weighted Average
Based on the information provided below, compute the Weighted Average Cost of Capital (WACC). The data includes the sources of capital, their required return rates, and the corporate tax rate:
- Common Stock and Retained Earnings: $400
- Preferred Stock: $100
- Corporate Bonds: $300
- Corporate Tax Rate: 35%
Paper For Above instruction
The calculation of the Weighted Average Cost of Capital (WACC) is a fundamental aspect of corporate finance, providing insight into the average rate of return a company must earn on its existing asset base to satisfy its investors and debt holders. The WACC considers the relative weights of each component of capital—equity, preferred stock, and debt—and adjusts for the cost of debt to reflect the tax deductibility of interest expenses. This paper demonstrates the calculation of WACC using the provided data for Acme International, highlighting how each component's cost and proportion contribute to the overall corporate valuation and investment decision-making process.
Step 1: Understanding the Components of Capital and Their Costs
The provided information indicates three sources of capital:
- Common Stock and Retained Earnings: $400
- Preferred Stock: $100
- Corporate Bonds (Debt): $300
Along with these, the corporate tax rate is given as 35%. The required return rates for each source are not explicitly provided in the problem statement, which appears to be a formatting oversight. To proceed with the calculation, standard assumptions or typical industry estimates are used. Typically, the cost of equity (referred to as the required return on common stock), cost of preferred stock, and cost of debt are estimated as follows:
- Cost of Equity (Re): Often estimated using the Capital Asset Pricing Model (CAPM). For this example, assume a generic required return of 12%, reflecting a typical high-growth industry.
- Cost of Preferred Stock (Rp): Usually around 8-10%. Assume 9% for this calculation.
- Cost of Debt (Rd): Usually based on current market rates or bond yields. Assume a 6% rate.
These assumptions enable us to demonstrate the calculation, but in real-world scenarios, the specific rates provided by the company should be used.
Step 2: Calculating the Total Capital
Total capital, or the sum of all sources, is calculated as:
Total Capital = Equity + Preferred Stock + Debt
= $400 + $100 + $300
= $800
Step 3: Calculating the Proportions of Each Capital Component
- Weight of Equity, \(w_e\) = \(\frac{400}{800} = 0.5\)
- Weight of Preferred Stock, \(w_{ps}\) = \(\frac{100}{800} = 0.125\)
- Weight of Debt, \(w_d\) = \(\frac{300}{800} = 0.375\)
Step 4: Computing the Cost Components
- Cost of Equity, \(Re\) = 12%
- Cost of Preferred Stock, \(Rp\) = 9%
- Cost of Debt, \(Rd\) = 6%
Since interest on debt is tax-deductible, the after-tax cost of debt is:
\[ R_{d, after-tax} = R_d \times (1 - Tax Rate) = 6\% \times (1 - 0.35) = 3.9\% \]
Step 5: Calculating the WACC
The WACC formula is:
\[ \text{WACC} = w_e \times Re + w_{ps} \times Rp + w_d \times R_{d, after-tax} \]
Plugging in the values:
\[ \text{WACC} = (0.5 \times 12\%) + (0.125 \times 9\%) + (0.375 \times 3.9\%) \]
\[ \text{WACC} = (0.5 \times 0.12) + (0.125 \times 0.09) + (0.375 \times 0.039) \]
\[ \text{WACC} = 0.06 + 0.01125 + 0.014625 \]
\[ \text{WACC} = 0.085875 \text{ or } 8.58\% \]
Conclusion
Based on the assumed costs and the provided capital structure, the Weighted Average Cost of Capital for Acme International is approximately 8.58%. This rate indicates the minimum return required by investors and debt holders to justify their investment, and it is essential for evaluating investment opportunities, valuing projects, and making strategic financial decisions.
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