Weighted Average Cost of Capital Applied to A Business Scenario, business and finance homework help


Question Description

Business Scenario: Innovative Company (fictional) has a targeted capital structure of 40% long-term debt and 60% common stock. The debt is yielding 6% and the corporate tax rate is 35%. The common stock is trading at $50 per share and next year's dividend is $2.50 per share that is growing by 4% per year.

Assignment Requirements: Write a minimum 900 word analysis that includes the following:

a. Calculate the firm's weighted average cost of capital (WACC). Use the dividend discount model. Show calculations in Microsoft Word.

b. The firm's CEO has stated if the company increases the amount of long-term debt so the capital structure will be 60% debt and 40% equity. This CEO further asserts that this strategy will lower its WACC. Explain and defend why you agree or disagree. Give an explanation of how you would advise the CEO.

c. Cite any works that you used in APA format. (If you prefer, MLA format would be fine as well.)

Tutor Answer

School: UIUC

Here it is. Feel free to follow up.


Weighted Average Cost of Capital
Student Name
Unit Code-Name of Institution




a) WACC= XD*KD*(1-T) + XCS *KCS
XD and XCS are weights of long-term debt and common stock respectively
KD is the pretax cost of long-term debt and
KCS is the cost of equity and;
T is the tax rate
Cost of Debt= XD*KD*(1-T)
= 0.4*0.06*0.65
Cost of Debt= 0.0156
Cost of Equity= XCS *KCS
KCS = D1/P0 + g
=2.5/50 +0.05
KCS= 0.1
Cost of Equity= 0.6*0.1
Cost of Equity= 0.06
WACC= 0.0156+0.06
WACC= 0.0756 or 7.56%
b) I disagree with the CEO’s assertion that the WACC reduces with an increase in
the weight of debt financing. Increasing the debt portion of the capital structure
may seem to be beneficial since the required rate of return on debt, as well as the
cost of debt, is lower than the required rate of return and cost of equity. The cost
of debt financing is also discounted by the tax rate since tax is deducted on
interest payments thereby creating a tax shield whose value is equal to the
interest payment multiplied by the existing tax rate since on every dollar of the
interest payment, the actual payment made by firms is (1-T). Increasing the ...

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