Final answer:
To calculate the company's cost of capital, we use the Capital Asset Pricing Model for equity costing 15%, and since the debt is risk-free, its cost is the treasury bill rate of 5%. Applying the weighted average cost of capital formula, the company's cost of capital is found to be 13%.
Step-by-step explanation:
The student asked a question regarding the calculation of a company's cost of capital given certain financial market parameters. To determine the company's cost of capital, we need to calculate the costs of equity and debt separately and then use a weighted average cost of capital (WACC) formula.
To calculate the cost of equity, we can use the Capital Asset Pricing Model (CAPM), which estimates the return on investment required by an equity investor. The CAPM formula is: Cost of Equity = Risk-Free Rate + Beta * Market Risk Premium. In this case, the student provided a Beta of 1.25 and a Market Risk Premium of 8%. Therefore, the cost of equity would be 5% (given as the treasury bill rate which is the risk-free rate) + 1.25 * 8% = 15%.
As the debt is risk-free, its cost is the same as the treasury bill rate, which is 5%. Now, to determine the company's overall cost of capital, we apply the WACC formula: WACC = (E/V * Re) + (D/V * Rd), where E is the market value of equity (20 million), V is the total market value of the firm's financing (E + D or 20 million + 5 million = 25 million), Re is the cost of equity (15%), and Rd is the cost of debt (5%).
Thus, WACC = (20 million / 25 million * 15%) + (5 million / 25 million * 5%) = 13%. The company's cost of capital is therefore 13%.