Question

Determine the weighted cost of capital for the Mills Company that will finance its optimal capital budget with $120 million of long-term debt (kd= 12.5%) and $180 million in retained earnings (ke = 16.0%). Mills' present capital structure is considered optimal. The company's marginal tax rate is 40%.

Answer 1

Answer:

The company's weighted cost of capital is 12.6%

Explanation:

Weighted average cost of capital (wacc) is calculated using the following formula:

wacc = [ kd x (1-tax) x weight of debt] + [ke x weight of equity]

in which: kd is the cost of debt = 12.5%

               ke is the cost of equity = 16%

Weight of debt = $120m / ($120m+$180m) = 40%

Weight of equity = $180m / ($120m+$180m) = 60%

--> wacc = [0.125 x ( 1-0.4) x 0.4] + [0.16 x 0.6]

              = 12.6%

Answer 2

The Weighted Cost of Capital (WACC) based on the debt, the tax rate, and the retained earnings is 12.6%.

The weighted average cost of capital can be calculated by the formula:

= ( Weight of debt x (1 - tax rate) x Cost of debt) + (Weight of equity x Cost of equity)

Weight of debt:

= Debt / (Debt + Retained earnings)

= 120 / (120 + 180)

= 40%

Weight of equity:

= 100% - 40%

= 60%

Weighted Cost of Capital:

= (40% x ( 1 - 40%) x 12.5%) + (60% x 16%)

= 12.6%

In conclusion, the WACC is 12.6%.

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