Question

Cromwell's Interiors is considering a project that is equally as risky as the firm's current operations.The firm has a cost of equity of 15.4 percent and a pretax cost of debt of 8.9 percent.The debt-equity ratio is .46 and the tax rate is 34 percent.What is the cost of capital for this project?A) 11.97 percentB) 12.40 percentC) 11.02 percentD) 11.62 percentE) 12.38 percent

Answer 1

Answer:

Cost of capital = 12.40% (Approx)

Explanation:

Given:

Cost of equity =  15.4%

Pretax cost of debt = 8.9%

Debt-equity ratio = 0.46

Tax rate = 34%

Computation:

Equity multiplier = 1 + Debt-equity ratio

Equity multiplier = 1 + 0.46

Equity multiplier = 1.46

Weight of equity = 1 / Equity multiplier

Weight of equity = 1 / 1.46

Weight of equity = 0.685

Weight of Debt = 1 - Weight of equity

Weight of Debt = 1 - 0.685

Weight of Debt = 0.315

Cost of capital = [Weight of Debt x Pretax cost of debt] x (1-tax rate) + [Cost of equity x Weight of Debt ]

Cost of capital = [0.315 x 8.9% x (1-0.34)] + [15.4% x 0.6849]

Cost of capital = 12.40% (Approx)