Fiscal Cliff Inc. has a capital structure that consists of 15 percent common stock and 85 percent long-term debt. In order to calculate Fiscal Cliff’s weighted average cost of capital, an analyst has accumulated the following information: · The company currently has 25-year bonds outstanding with annual coupon payments of 8 percent. The bonds have a face value of $1,000 and sell for $700. · The risk-free rate is 3 percent. · The market risk premium is 8 percent. · The beta on Fiscal Cliff's common stock is 2.3. · The company's retained earnings are sufficient so that they do not have to issue any new common stock to fund capital projects. · The company's tax rate is 40 percent. Given this information, what is Fiscal Cliff's WACC? A. 9.21% B. 12.58% C. 8.17% D. 7.63% E. 11.35%

WACC= 8.7%

Explanation:

The weighted Average cost of Capital is the average cost of capital for the different sources of long-term capital available to a firm weighted according to the proportion each source of finance bears to the total capital in the pool.

The Weighted average cost of debt can be worked out using the following steps:

Step 1: Cost of debt

The cost of debt is the same as the yield to maturity. The yield to maturity to Maturity can be used to work out the cost of debt using the formula below:

YM =( C + F-P/n) ÷ ( 1/2× (F+P))

C- annual coupon,

F- face value ,

P- current price,

n- number of years to maturity

YM - Yield to maturity

C- 8%× 1000 =80 , P= 700, F- 1000

AYM = 80 + (1000-700)/25÷ 1/2× (1000+700)

= 92 ÷ 850

= Yield to maturity = 10.82%

After-tax cost of debt=Before-tax × (1-T)

After-tax cost of debt = 10.82%× (1-0.4) =6.49%

Step 2 : Cost of equity

This can be computed using the Capital Asset pricing model

Ke= Rf +β(Rm-Rf)

Ke =? , Rf- 3%, β- 2.3, Rm-Rf= 8%

Ke= 3% + 2.3× 8%

Cost of equity = Ke =21.4%

Step 3: WACC

WACC = (15%*21.4.5)  + (85%*6.49)=8.7%

WACC= 8.7%

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