A firm has a target capital structure comprising 60% Equity and 40% Debt. The Cost of Equity is 14.0%, the pre-tax Cost of Debt is 8.0%, and the corporate tax rate is 25%. What is the firm's Weighted Average Cost of Capital (WACC)?

[ A ]11.60 percent per annum

[ B ]14.00 percent per annum

[ C ]8.40 percent per annum

[ D ]10.80 percent per annum[ CORRECT ]

Takeaway

Option D is correct: 10.80 percent per annum

Derivation

WACC combines the required returns of equity and debt weighted by their proportion in the capital structure, factoring the interest tax shield on debt: Formula: WACC = [Ke * We] + [Kd * (1 - Tax Rate) * Wd]. Given: We = 0.60, Ke = 14.0%, Wd = 0.40, Kd = 8.0%, Tax = 25% (0.25). After-tax Cost of Debt = 8.0% * (1 - 0.25) = 8.0% * 0.75 = 6.0%. WACC = [14.0% * 0.60] + [6.0% * 0.40] = 8.40% + 2.40% = 10.80% per annum. WACC serves as the discount rate for FCFF to arrive at Enterprise Value. This tests WACC computation. The common error is using pre-tax debt (8%) yielding 11.60%.

Why the others fail

A — 11.60 percent per annum

11.60% fails to apply the corporate tax shield on debt interest ([14% * 0.60] + [8% * 0.40] = 8.4 + 3.2 = 11.60%).

B — 14.00 percent per annum

14.00% represents only the cost of equity, ignoring the lower cost of debt in the capital structure.

C — 8.40 percent per annum

8.40% represents only the equity contribution portion (14% * 0.60) without adding the after-tax debt cost.