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The Weighted Average Cost of Capital (WACC) id the minimum after tax returns that a business must earn its shareholders. WACC is calculate by determining the cost of each component of the company’s capital structure and dividing it with the weight of the component. This ratio is important in evaluating the most affordable source of financing that a business should adopt to maximize its shareholder’s wealth.

**Calculation of WACC**

WACC= E/(E+D+P)× r_{e} + D/(E+D+P)× (1-t)×r_{d} + P/(E+D+P)× r_{p}

Which is similar to:

WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)+ r(P) × w(E)

E = Market value of equity

D = Market value of debt

P = Market value of preferred stock

r_{e} = Cost of equity

r_{d} = Cost of debt

r_{p} = Cost of preferred stock

t = Marginal tax rate

1-t = Tax shield

** **

**MM Pizza**

Current WACC is 8%

Market risk r_{m} is 5%

Beta is 0.8 (Unlevered)

Cost of Equity is 8%

Cost of Debt is 4%

Risk free rate is 4%

Corporate tax is 20%

**After Borrowing Cost**

Weighted average cost Millions

Current market value of equity 1000

Current market value of debt __500__

Total Market value __1500__

Weight of equity 66.67%

Weight of debt 33.33%

Cost of Equity

r_{e}= r_{f}+ β×(r_{m} − r_{f})

Where:

r_{f} = Risk-free rate (represented by 10-yr U.S. Treasury bond rate)

β = Predicted equity beta (levered)

(r_{m} − r_{f}) = Market risk premium

Levered β= Unlevered β× [1 + [(D/E) × (1−t) + P/E]]

With Tax

Levered β= 4% × [1+ (500/1000)× 0.8)]

Levered β= 5.6%

Cost of equity using CAPM

Cost of Equity = Risk Free Rate + Beta × Market Risk Premium

Cost of Equity= 4+ (5.6 (5-4))= 9.6%

Weighted cost of equity= 0.667× 9.6%= 6.40%

No Tax

Levered β= 4% × [1+ (500/1000)× 1.0)]

Levered β= 6%

Cost of equity using CAPM

Cost of Equity = Risk Free Rate + Beta × Market Risk Premium

Cost of Equity= 4+ (6 (5-4))= 10%

Weighted cost of equity= 0.667× 10%= 6.67%

**Weighted Cost of Debt**

- Debt and Tax

D/(E+D+P)× (1-t)×r_{d}

500/1500× 0.8×4%= 1.067

WACC= weight of equity + Weight of debt

WACC= 6.4+ 1.067= 7.467%

- No debt and tax

D/(E+D+P)× (1-t)×rd

0/1500× 0.8×4%= 0

WACC= weight of equity + Weight of debt

WACC= 6.4+ 0= 6.4%

- No debt and no tax

D/(E+D+P)× (1-t)×rd

0/1500× 1×4%= 0

WACC= weight of equity + Weight of debt

WACC= 0/1500× 1×4%= 0

- Debt and no tax

D/(E+D+P)× (1-t)×rd

500/1500× 1×4%= 1.33%

WACC= weight of equity + Weight of debt

WACC= 6.67+ 1.33= 8.0%

**Conclusion**

From the analysis, the new WACC is 7.467% where there is debt and tax, 6.4% where there is no debt but there is tax. It is 6.67% where there is no debt and no tax, and 8.0% where there is debt and no tax. Therefore, Millner should use this method to raise capital in all scenarios since they all have a WACC lesser than 8% except where there is debt and no tax, where still the WACC is 8%. In addition, the use debt enables the business to increase its capital base by 500 million without diluting shareholder’s ownership of the company.