The CFA® Level 1: CFA® Level 1 Exam

Weighted Average Cost of Capital Calculation

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A firm's capital structure has a debt-to-equity ratio of 0.8. The pretax cost of debt is 7%. The beta of the stock is 1.3 in an environment with risk-free rate of 5.5% and an expected market return of 16%. The firm is in the 45% tax bracket. The weighted average cost of capital of the firm equals ________.

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A. B. C. D.

A

Using CAPM, the cost of equity equals 5.5% + 1.3*(16% - 5.5%) = 19.15%. Since the debt interest is tax deductible, the after-tax cost of debt equals 7%*(1-0.45) =

3.85%. Now, the D/E ratio = 0.8. Hence, (D+E)/E = 1.8, giving E/(D+E) = 0.556. Thus, equity forms 55.6% of the capital while debt forms 44.4%. The WACC is then equal to 0.556*19.15% + 0.444*3.85% = 12.35%.

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