Blammo,Inc.has a target capital structure of 30% debt and 70% equity.The firm is planning to invest in a project that will necessitate raising new capital.New debt will be issued at a before-tax yield of 14%,with a coupon rate of 10%.The equity will be provided by internally generated funds so no new outside equity will be issued.If the required rate of return on the firm's stock is 22% and its marginal tax rate is 35%,compute the firm's cost of capital.
A) 18.00%
B) 18.13%
C) 19.68%
D) 15.55%

Question

Quizplus · Accepted Answer

First, we need to calculate the weight of each component of the capital structure:

Debt weight = 30%
Equity weight = 70%

Next, we need to determine the after-tax cost of debt:

Before-tax yield = 14%
Marginal tax rate = 35%
After-tax cost of debt = 14% x (1 - 35%) = 9.10%

Finally, we can calculate the firm's cost of capital using the following formula:

Cost of capital = (weight of debt x after-tax cost of debt) + (weight of equity x required rate of return on equity)

Cost of capital = (0.30 x 9.10%) + (0.70 x 22%) = 2.73% + 15.40% = 18.13%

Therefore, the best choice is B) 18.13%.