Explanation

To calculate the Weighted Average Cost of Capital (WACC), we need to follow these steps:

Step 1: Calculate Market Values

1. Market value of equity:

   • Share price = $60
   • Shares outstanding = 10 million
   • Market value of equity = $60 × 10 million = $600 million

2. Market value of debt:

   • Given as $150 million

3. Total market value of the firm:

   • Total value = Market value of equity + Market value of debt
   • Total value = $600 million + $150 million = $750 million

Step 2: Calculate Weights

1. Weight of equity (wₑ):

   • wₑ = Market value of equity / Total value
   • wₑ = $600 million / $750 million = 0.80 or 80%

2. Weight of debt (wₒ):

   • wₒ = Market value of debt / Total value
   • wₒ = $150 million / $750 million = 0.20 or 20%

Step 3: Apply Tax Adjustment to Cost of Debt

• Cost of debt (before tax) = 4%
• Tax rate = 30%
• After-tax cost of debt = Cost of debt × (1 - Tax rate)
• After-tax cost of debt = 4% × (1 - 0.30) = 4% × 0.70 = 2.8%

Step 4: Calculate WACC

WACC = (wₑ × Cost of equity) + (wₒ × After-tax cost of debt)

WACC = (0.80 × 7%) + (0.20 × 2.8%)

WACC = (0.80 × 0.07) + (0.20 × 0.028)

WACC = 0.056 + 0.0056

WACC = 0.0616 or 6.16%

Step 5: Verify Calculation

• Equity component: 80% × 7% = 5.60%
• Debt component: 20% × 2.8% = 0.56%
• Total: 5.60% + 0.56% = 6.16%

Key Points:

1. Always use market values (not book values) for WACC calculations
2. Apply tax adjustment to the cost of debt
3. The weights must sum to 100%
4. The correct answer is 6.16% (Option A)