Final answer:
The company's cost of capital, calculated using the Weighted Average Cost of Capital (WACC) formula and assuming no taxes, is 13%. This incorporates the cost of equity determined through the Capital Asset Pricing Model (CAPM) and the cost of debt, equivalent to the risk-free rate of 5%.
Step-by-step explanation:
The question asks how to calculate the company's cost of capital using the market value of equity, the market value of debt, the stock's beta, the market risk premium, and the risk-free rate. This is done using the Weighted Average Cost of Capital (WACC) formula for a company with no taxes. The WACC is the average rate of return a company is expected to pay its security holders to finance its assets.
The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), which is:
Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium
This gives us:
Cost of Equity = 5% + 1.25 * 8% = 15%
Since the debt is risk-free, its cost is simply the risk-free rate, which is 5%.
The company's cost of capital (WACC) is then:
WACC = (Equity Value / (Equity Value + Debt Value)) * Cost of Equity + (Debt Value / (Equity Value + Debt Value)) * Cost of Debt
WACC = ($20 million / ($20 million + $5 million)) * 15% + ($5 million / ($20 million + $5 million)) * 5%
WACC = ($20 million / $25 million) * 15% + ($5 million / $25 million) * 5%
WACC = 0.8 * 15% + 0.2 * 5%
WACC = 12% + 1%
WACC = 13%