Question

Armadillo Mfg. Co. has a target capital structure of 50% debt and 50% equity. They are planning to invest in a project which will necessitate raising new capital. New debt will be issued at a before-tax yield of 12%, with a coupon rate of 10%. The equity will be provided by internally generated funds. N new outside equity will be issued. If the required rate of return on the firm's stock is 15% and its marginal tax rate is 40%, compute the firm's cost of capital.

1. 11.1%
2. 7.2%
3. 13.5%
4. 12.5%

Answer 1

The firm's cost of capital for Armadillo Mfg. Co., considering its target capital structure of 50% debt and 50% equity, along with the given costs for debt and equity, and accounting for taxes, is 11.1%, which is option 1.

Step-by-step explanation:

To compute the firm's cost of capital for Armadillo Mfg. Co., we need to take into account both the cost of debt and the cost of equity. The firm's capital structure is a split of 50% debt and 50% equity. For debt, the cost is the after-tax yield since interest is tax-deductible. Therefore, the cost of debt (Kd) is the before-tax yield (12%) adjusted for the tax rate (40%), resulting in Kd = 12% * (1 - 0.40) = 7.2%.

The cost of equity (Ke) is given as the required rate of return on the firm's stock, which is 15%. Since the capital structure is evenly split, the weighted average cost of capital (WACC) is the average of the two costs. Hence, WACC = (0.50 * 7.2%) + (0.50 * 15%) = 3.6% + 7.5% = 11.1%.

Therefore, the firm's cost of capital is 11.1%, which aligns with option 1.