Donner,Inc.will finance a proposed investment by issuing new securities while maintaining its optimal capital structure of 60% debt and 40% equity.The firm can issue bonds at a price of $950.00 before $15 flotation costs.The 10-year bonds will have an annual coupon rate of 8% and a face value of $1,000.The company can issue new equity at a before-tax cost of 16% and its marginal tax rate is 34%.What is the appropriate cost of capital to use in analyzing this project?
A) 3.63%
B) 8.77%
C) 9.97%
D) 11.81%

Question

Quizplus · Accepted Answer

To calculate the appropriate cost of capital, we need to calculate the weighted average cost of capital (WACC) for Donner, Inc.

WACC = (Cost of Equity * Equity Proportion) + (Cost of Debt * Debt Proportion * (1 - Tax Rate))

Equity Proportion = 0.4
Debt Proportion = 0.6
Cost of Equity = 16%
Cost of Debt = (Annual Coupon * (1 - Flotation Costs) / Bond Price) = (80 / (950 * (1 - 0.15))) = 9.97%
Tax Rate = 34%

WACC = (0.16 * 0.4) + (0.0997 * 0.6 * (1 - 0.34)) = 0.0392 + 0.0380 = 0.0772 or 7.72%

Therefore, the appropriate cost of capital to use in analyzing this project is 7.72%.

The best choice is C.