US CMA Part 2 · Chapter 3 · Question 13 of 15
Dalton Freight's target capital structure is 40% debt, 10% preferred stock and 50% common equity. Its before-tax cost of debt is 7%, tax rate 25%, cost of preferred stock 8% and cost of common equity 12%. What is its weighted average cost of capital?
Test yourself: pick an answer
Reveal answer & explanation
Correct answer: C) 8.90%
Explanation
After-tax cost of debt = 7% x (1 - 0.25) = 5.25%. WACC = (0.40 x 5.25%) + (0.10 x 8%) + (0.50 x 12%) = 2.10% + 0.80% + 6.00% = 8.90%. Using the pre-tax debt cost gives 9.60%. Preferred dividends are not tax-deductible, so the cost of preferred stock is not adjusted for tax.
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