If VersaLife Corporation issues new debt, then the bond market expects a yield of 7.5%. Preferred stock is trading for $96, has a $100 par value and pays an annual dividend of 8% (the next dividend is due in one year). Common equity has a beta of 1.20, the market risk premium is 5%, and the risk-free rate is 3%. If the firm's tax rate is 40%, what is the weighted average cost of capital

7.17%

Explanation:

For determining the weighted average cost of capital first we need to find out the after cost of debt and cost of preferred stock and the cost of common equity which are as follows

Cost of debt is

= Yield × (1 - tax rate)

= 7.5% × (1 - 40%)

= 4.5%

Cost of preferred stock is

= Dividend ÷ price

= 8 ÷ $96

= 8.33%

And, Cost of common equity is

= risk free rate + beta ×  market risk premium

= 3% + 1.2 × 5%

= 9%

Now the weighted average cost of capital is

WACC = cost of debt × weight of debt + cost of preferred stock × weight of preferred stock + cost of common equity × weight of common equity

= 4.5% × $80 ÷ ($80 + $10 + $110) + 8.33% × $10 ÷ (80 + $10 + $110) + 9% × $110 ÷ ($80 + $10 + $110)

= 7.17%