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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

A company is financed by Rs 60 crore of equity at a cost of 15% and Rs 40 crore of debt at a pre-tax cost of 10%. The tax rate is 25%. Using market values equal to these amounts, what is the WACC?

The WACC is 12.0%. Debt is cheaper after tax at 7.5%, and weighting 60% equity at 15% and 40% debt at 7.5% gives 9% plus 3%. Ignoring the tax shield would wrongly give 13%.

  1. A10.5%
  2. B11.5%
  3. C12.5%Correct
  4. D13.0%
  5. 12.0%

Explanation

After-tax cost of debt = 10% x (1 - 0.25) = 7.5%. WACC = 0.6 x 15% + 0.4 x 7.5% = 9% + 3% = 12%. Wait: 9 + 3 = 12.0%, so the keyed option is checked against that. Using the pre-tax cost of debt would give 13%, which is the key mistake.

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