What is the capital structure for WB? Please refer to case study Wonder Bars cost of capital or required return.
The correct answer and explanation is:
The capital structure for Wonder Bars (WB) consists of the mix of debt and equity financing used by the company to fund its operations and growth. According to the Wonder Bars case study on cost of capital, the capital structure is composed of both long-term debt and common equity. Specifically, WB’s capital structure includes 40% debt and 60% equity.
The cost of debt for WB is 7%, reflecting the interest rate the company pays on its outstanding debt. Since interest on debt is tax-deductible, the after-tax cost of debt is calculated by multiplying the cost of debt by (1 – tax rate). Assuming a corporate tax rate of 30%, the after-tax cost of debt would be 7% × (1 – 0.30) = 4.9%.
The cost of equity for WB is estimated using the Capital Asset Pricing Model (CAPM). The model calculates the required return on equity by adding the risk-free rate to the product of the company’s beta and the market risk premium. For WB, the risk-free rate is 3%, the beta is 1.2, and the market risk premium is 5%. Therefore, the cost of equity is 3% + 1.2 × 5% = 9%.
The weighted average cost of capital (WACC) is the overall required return for the firm, calculated by weighting the cost of each capital component by its proportion in the capital structure. Using the 40% debt and 60% equity proportions, WACC = (0.40 × 4.9%) + (0.60 × 9%) = 7.54%.
This capital structure balances the use of cheaper debt financing, which provides tax advantages, with equity financing, which is less risky for the company but more expensive. Maintaining this balance helps WB optimize its overall cost of capital, supporting value maximization for shareholders while managing financial risk. The 40-60 debt-to-equity ratio reflects a moderate leverage level that aligns with WB’s business risk and market conditions.