The market value of Charter Cruise Company's equity is $15 million, and the market value of its risk-free debt is $5 million. If the required rate of return on the equity is 20% and that on the debt is 8%, calculate the company's cost of capital. (Assume no taxes.)

Question

Quizplus · Accepted Answer

Firstly, we need to find the weights of equity and debt in the company's capital structure:
Weight of Equity = Market Value of Equity / Total Market Value
= 15 / (15 + 5) = 0.75
Weight of Debt = Market Value of Debt / Total Market Value
= 5 / (15 + 5) = 0.25

Next, we can calculate the cost of equity using the Capital Asset Pricing Model (CAPM):
Cost of Equity = Risk-Free Rate + Beta * (Expected Market Return - Risk-Free Rate)
Since the question does not provide information on the company's beta or expected market return, we cannot use CAPM to calculate the cost of equity.

Instead, we can use the information provided in the question to calculate the Weighted Average Cost of Capital (WACC):
WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt
= 0.75 * 20% + 0.25 * 8%
= 17%

Therefore, the company's cost of capital is 17%, which is option B.

The Market Value of Charter Cruise Company's Equity Is $15