CoffeeStop primarily sells coffee. It recently introduced a premium coffee-flavored liquor (BF Liquors). Suppose the firm faces a tax rate of 40 % and collects the following information. If it plans to finance 10 % of the new liquor-focused division with debt and the rest with equity, what WACC should it use for its liquor division? Assume a cost of debt of 5.4 %, a risk-free rate of 2.3 %, and a market risk premium of 6.7 %.

CoffeeStop should use a WACC of  8.42%

Explanation:

Weighted Average Cost of Capital (WACC) is the minimum return that a project must offer before it can be accepted.

Calculation of WACC

Capital Source               Weight              Cost                 Total

Debt                                  10 %               3.24%              0.32%

Equity                               90%                 9%                  8.10%

Total                                100%                                        8.42%

Weight

Note : CoffeeStop plans to finance 10 % of the new liquor-focused division with debt and the rest with equity

Cost of Debt

WACC calculation considers the after tax cost of debt

Cost of Debt = Market Interest Rate × (1-tax rate)

                     = 5.4 % × (1-0.40)

                     = 3.24%

Cost of Equity

Cost of Equity = Risk free rate + Beta × Market Premium

                       = 2.3 % + 6.7 %

                       = 9%

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