A firm plans to raise $4 million by borrowing at an interest rate of 16 percent and to raise $1 million by issuing common stock. The firm's stock has a beta coefficient of 2, the risk-free interest rate is 6 percent, the average rate of return on stocks is 9 percent, and the marginal tax rate is 25 percent. What is the firm's composite cost of capital?

Question

Quizplus · Accepted Answer

The firm's composite cost of capital is calculated by finding the weighted average cost of capital (WACC), which includes the costs of debt and equity. The cost of debt after taxes is 16%*(1-0.25) = 12%. The cost of equity can be calculated using the Capital Asset Pricing Model (CAPM), which is Risk-Free Rate + Beta*(Market Rate - Risk-Free Rate) = 6% + 2*(9%-6%) = 12%. The firm is raising $4 million through debt and $1 million through equity, so the total is $5 million. The weighted cost is (4/5)*12% + (1/5)*12% = 12%.

A Firm Plans to Raise $4 Million by Borrowing at an Interest