Chapter 13 Cost of Capital Text Probs and Solns

Chapter 13 Cost of Capital Text Probs and Solns - Chapter...

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1 Chapter 13 The Cost of Capital (WACC) Self-Study Problems 13.2 Berron Comics, Inc., has borrowed $100 million and is required to pay its lenders $8 million in interest this year. If Berron is in the 35 percent marginal tax bracket, then what is the after-tax cost of debt (in dollars as well as in annual interest) to Berron. Solution: Because Berron enjoys a tax deduction for its interest charges, the after-tax interest expense for Berron is $8 million × (1 – 0.35) = $5.2 million, which translates into an annual interest expense of $5.2/$100 = 0.052, or 5.2 percent. 13.3 Explain why the after-tax cost of equity (common or preferred) does not have to be adjusted by the marginal income tax rate for the firm. Solution: The U.S. tax code allows a deduction for interest expense incurred on borrowing. Preferred and common shares are not considered debt and, thus, do not benefit from an interest deduction. As a result, there is no distinction between the before-tax and after-tax cost of equity capital. 13.4 Mike’s T-Shirts, Inc., has debt claims of $400 (market value) and equity claims of $600 (market value). If the after-tax cost of debt financing is 11 percent and the cost of equity is 17 percent, then what is Mike’s weighted average cost of capital?
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