SIROM Scientific Solutions has $10 million of outstanding equity and $5 million of bank debt. The bank debt costs 5% per year. The estimated equity beta is 2. If the market risk premium is 9% and the risk-free rate is 3%, compute the weighted average cost of capital if the firm's tax rate is 30%.

The weighted average cost of capital is 15.167%

Explanation:

In this question, we are interested in calculating the weighted average cost of capital of the firm.

Weighted average cost of capital = (Weight of debt * cost of debt) + (weight of equity * cost of equity)

Firstly, we shall be calculating the cost of equity.

Mathematically,

cost of equity = Risk free rate + (beta * market risk premium)

From the question, the risk free rate is 3% , equity beta is 2 and the market risk premium is 9%

Inputing these values;

Cost of equity = 3% + (2 * 9%) = 3% + 18% = 21%

Now, we proceed to calculate the after tax cost of debt

Mathematically, after tax cost of debt = Cost of debt ( 1- Tax rate)

From the question, cost of debt = 5%

Tax rate = 30% = 30/100 = 0.3

Plugging these values

After tax cost of debt = 5(1-0.3) = 5(0.7) = 3.5%

Weight of debt = bank debt/(outstanding equity + bank debt) = 5/(5+10) = 5/15

Weight of equity = outstanding equity/(bank debt + outstanding equity) = 10/(5+10) = 10/15

Now, plugging these values into the weighted average cost of capital formula, we have;

(5/15 * 3.5) + (10/15 * 21) = 1.167 + 14 = 15.167%

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