Please explain and show all work. Cost of capital is often a significant compone
ID: 2708930 • Letter: P
Question
Please explain and show all work.
Cost of capital is often a significant component affecting the expected returns. If the cost of capital is high, then the expected returns demanded of an investment may be more than it can provide, making the project unattractive. The cost of capital can be calculated using a weighted average of the cost of debt and the cost of equity according to the following equation:
COC=Cd*Rd+Ce*Re
Where:
Cd is the cost of debt
Ce is the cost of equity, and
Rd is the ratio of debt to total assets that is equal to the debt/equity leverage ratio (L) divided by 1+L
Rd=L/(1+L)
Re is the ratio of equity to total assets, and is equal to 1-Rd
The investor has $2.3 million in debt and $1.7 million in equity. They find that their cost of equity is 10.2%, and the cost of debt based on existing loans is 3.4%. What is their cost of capital?
Explanation / Answer
COC=Cd*Rd+Ce*Re
Cd is the cost of debt=3.4%
Ce is the cost of equity, and=10.2%
Rd is the ratio of debt 2.3million
Re is ratio of equity =1.7million
COC=3.4%*2.3+10.2%*1.7=0.0782+0.1734=$0.2516millions or $25.16%millions