chopter Problem 1t2 can beuya and debtLater n the yean tte m

chopter Problem 1t-2. can beuya and debt.Later n the yean tte m urne Finen end 131 cost of eguiy Compute-tle weighted-oueroge-ces

Solution

a. Let’s calculate the weighted cost of capital (WACC)

WACC = wd * rd (1 - t) + we*re                

Where,

The weight of equity in Firm’s capital structure, we = 50% = 0.5

The weight of debt in Firm’s capital structure, wd = 50% = 0.5

The before-tax cost of debt, rd = 6%

The company’s tax rate, t = 0% (assume that there is no tax as no information regarding tax is given in the question)

The cost of equity, re = 18%

Therefore,

WACC = 0.5 * 6% * (1-0%) + 0.5 * 18%

= 3% + 9.0%

= 12%

The weighted cost of capital (WACC) is 12%

b. The projects which have expected rates of return (or yield) more than the weighted average cost of capital (WACC) will be accepted. The project with expected return of 9% has return less than its cost of capital of 12%, therefore it should be rejected and the project with expected return of 16% has return more than its cost of capital of 12%, therefore it should be accepted.