Question

a company is 40% financed by debt. the interest rate is 10%, the expected market risk premium is 8%, and the beta of the company's common stock is 0.5. what is the company cost of capital? type your answer using two decimal places. you do not need to type the % sign

Answer 1

The company's cost of capital is 7.60%, calculated using the weighted average cost of capital (WACC) which combines the costs of debt and equity.

Step-by-step explanation:

The company's cost of capital is a weighted average of the cost of debt and the cost of equity, known as the weighted average cost of capital (WACC). Since we know the company is 40% financed by debt at an interest rate of 10%, the cost of debt before taxes is 4% (0.40 * 10%). The company's cost of equity can be calculated using the CAPM (Capital Asset Pricing Model), which is the risk-free rate plus the beta times the market risk premium. Assuming the risk-free rate is 2%, which is typically close to the yield on government bonds, the cost of equity would be 2% + 0.5 * 8% = 6%. So the weighted costs are 4% (debt) and 6% (equity).

Since the company is 60% financed by equity (100%-40%), the weighted equity cost is 3.6% (0.60 * 6%). Therefore, the company's WACC is the sum of its weighted costs of debt and equity, which is 4% + 3.6% = 7.60%.