Ewer firm will finance a proposed investment by issuing new securities while mai

Question

Ewer firm will finance a proposed investment by issuing new securities while maintaining its optimal capital structure of 60% debt and 40% equity. The firm can issue bonds at price of $950.00 before $15 flotation costs. The 10-year bonds will have an annual coupon rate of 8% and face value of $1,000. The company can issue new equity at a before- tax cost of 16% and its marginal tax rate at 34%. What is the appropriate cost of capital use in analyzing this project?
a) 9.97%
b) 3.36%
c) 11.81%
d) 8.77%

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Explanation / Answer

According to the given information, Weight of debt = 60% Weight of equity = 40% Issue price of the bonds = $950 - $15                                      = $935 Face value of the bond = $1000 Years to maturity = 10yrs Coupon rate = 8% Annual coupon payment = Face value * Coupon rate                                      = $1000 * 8%                                      = $80 Cost of equity = 16% Computing the cost of debt using excel sheet: Step1: Go to excel and click "insert" to insert the function. Step2: Select the "Rate" function as we are finding the yield to maturity in this case. Step3: Enter the values as Nper = 10; PMT = -80; PV = 935; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "9.01%" Now, we have to calculate the cost of capital using the formula, Cost of capital = Weight of debt * Cost of debt * (1 - Tax rate ) + Weight of equity * Cost of equity                        = 0.60 * 0.0901 * (1 - 0.34) + 0.4 * 0.16                       = 0.357 + 0.064                       = 0.997 or 9.97% Therefore, Cost of capital is 9.97% The correct option is a) 9.97%

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