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Capital Structure in a Perfect Market

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Mike's Motors has 30 million shares outstanding with a price of $15 per share. In addition, Mike has issued bonds with a total current market value of $150 million. Suppose Rumolt's equity cost of capital is 10%, and its debt cost of capital is 5%.

a. What is Mike's pretax weighted average cost of capital?
Pretax weighted average cost of capital =

b. If Mike's corporate tax rate is 35%, what is its after-tax weighted average cost of capital?
After-tax weighted average cost of capital =

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Solution Preview

The value of a firm is the total market value of its securities. Therefore, the value of this firm is:

Security Value

Common Stock $450,000,000 (30,000,000 shares *$15/share)
Bonds 150,000,000 (Given)
Total Firm Value 600,000,000

a. The weighted average cost of capital is computed as: WACC=(Cost of Equity*(Value of Equity/Total Firm Value))+(Cost of Debt*(Total Value of Debt/Total Firm Value). In this case, the ...

Solution Summary

This solution discusses the computation of the required calculations, the pretax and after-tax weighted average cost of capital, and provides all of the required steps for solving. Charts are also used to organize the value of the firms securities in an organized manner.