Question

Faraday Enterprises is a publicly traded company. It currently has 10 million shares trading at $12/share and $150 million in book value of equity. The firm also has book value of debt of $ 75 million and market value of debt of $ 80 million. The cost of equity for the company is 9%, the pre-tax cost of debt is 4% and the marginal tax rate is 40%. What is the cost of capital?

Answer 1

6.36%

Step-by-step explanation:

Weighted Average Cost of Capital (WACC) is the minimum return that is expected from a project.It shows the risk of the company

WACC = Cost of Equity + Cost of Debt

Capital Source Market Value Weight Cost Total Cost

Equity $120,000,000 60% 9% 5.40%

Debt $80,000,000 40% 2.40% 0.96%

Total $200,000,000 100% 6.36%

Cost of Debt = Market Interest rate × ( 1 - tax rate)

= 4 % × (1 - 0.40)

= 2.40%

Therefore, cost of capital is 6.36%

Answer 2

6.36%

Step-by-step explanation:

First we calculate the market value weights of debt and equity,

Debt to the capital ratio is calculated as,

80,000,000/(120,000,000+80,000,000) = 40%.

Therefore Equity ratio will be: (100%-40%) = 60%.

Now,

Cost of capital = (0.6*9%) + (0.4*4%)(1 - 40%) = 6.36%.

Hope this helps.

Goodluck buddy.