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Sunny Flowers is considering the purchase of a small business that costs $500,000. Sunny plans to sell stock valued at $250,000. The stock would pay dividends of $20,000 per year. Sunny would borrow the remaining $250,000 from a local bank at 12 percent interest.
The business is expected to generate annual cash inflows of $80,000. Duane plans to operate the business for 15 years and then turn it over to his son.
-The cost of capital for the firm is
A) 8%.
B) 6%.
C) 10%.
D) 12%.

Question

Quizplus · Accepted Answer

To determine the cost of capital, we need to calculate the weighted average cost of all the sources of funding.

Equity:
The equity portion of the funding is $250,000 and generates $20,000 per year in dividends. Therefore, the cost of equity is $20,000/$250,000 = 8%.

Debt:
The debt portion of the funding is $250,000 and has an interest rate of 12%.

Weighted average cost of capital:
The weighted average cost of capital (WACC) is calculated as the weighted sum of the cost of equity and the cost of debt, where the weights are the proportion of each funding source in the total capitalization.

WACC = (Equity/Total capital) x Cost of equity + (Debt/Total capital) x Cost of debt

Total capital = Equity + Debt = $500,000

WACC = ($250,000/$500,000) x 8% + ($250,000/$500,000) x 12% = 10%

Therefore, the cost of capital for the firm is 10%. The best choice is C.

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