Question

Bay Beach Industries wants to maintain their capital structure of 40% debt and 60% equity. The firm's tax rate is 34%. The firm can issue the following securities to finance the investments: bonds, mortgage bonds can be issued at a pre-tax cost of 7.1 percent, debentures can be issued at a pre-tax cost of 9.2 percent, common equity can be financed through retained earnings and new common stock. What is the cost of capital using mortgage bonds and internal equity?

Answer 1

The cost of capital calculation for Bay Beach Industries requires the weighted average of the post-tax cost of mortgage bonds and the cost of internal equity based on their desired capital structure.

Step-by-step explanation:

The cost of capital using mortgage bonds and internal equity for Bay Beach Industries, which wants to maintain their capital structure of 40% debt and 60% equity, involves calculating the weighted average cost of capital (WACC). The cost of debt (using mortgage bonds) is 7.1%, but we need to consider the tax shield this provides due to their tax rate of 34%. The effective cost of debt post-tax is calculated as 7.1% x (1 - 0.34), which simplifies to 4.686%. Similarly, although the cost of internal equity is not provided within the question, we typically use the cost of retained earnings or the required return on equity. The WACC is then calculated by multiplying each component's cost by its respective percentage in the capital structure and adding them up, assuming here that the equity component has a certain cost which is not specified in the question. However, to give an accurate answer, the cost of equity is required.