Choice "C" is correct. The weighted-average cost of capital (WACC) is 9.8%. Computation of the weighted-average cost of capital purely weights the cost of each form of capital financing with its relative percentage of total financing. The cost used for the WACC is the after-tax cost of capital.The scenario above provides a number of capital financing instruments and their relative weight in the capital structure. Debt costs are reduced by tax benefits while common and preferred equity costs are not. The WACC is computed as follows:
| Pre-tax
| | Tax
| | After-tax
| | Weight
| | Product
|
|---|
Debt | 10% | × | (1 − .3) | | 7% | × | 40% | = | 2.8% |
Common | 10% | × | n/a | = | 10% | × | 50% | = | 5.0% |
Preferred | 20% | × | n/a | = | 20% | × | 10% | = | 2.0% |
WACC | | | | | | | | | 9.8% |
Choice "d" is incorrect. The proposed solution anticipates that all financing has a tax benefit and goes on to use a computed after-tax rate for all financing. Only debt benefits from a tax deduction for the financing charges, even when correctly applied.
Choice "a" is incorrect. The proposed solution anticipates that all financing has a tax benefit and uses a computed after-tax rate for all financing. Only debt benefits from a tax deduction for the financing charges.
Choice "b" is incorrect. The proposed solution uses the tax benefit rather than the after-tax rate to compute WACC.
