Brewster's is considering a project that is equally as risky as the firm's current operations. The firm has a cost of equity of 13.7 percent and a pre-tax cost of debt of 8.4 percent. The debt-equity ratio is .65 and the tax rate is 36 percent. What is the cost of capital for this project?

Question

Quizplus · Accepted Answer

First, we need to calculate the weights of equity and debt in Brewster's capital structure:

Equity weight: 1 - 0.65 = 0.35
Debt weight: 0.65

Next, we can calculate the cost of equity using the CAPM formula:

Cost of equity = Risk-free rate + Beta x Equity risk premium

We are not given the risk-free rate or the beta, so we cannot directly calculate the cost of equity. However, we are told that the cost of equity is 13.7 percent. Therefore, we can use this information to solve for the equity risk premium:

Equity risk premium = Cost of equity - Risk-free rate = 13.7% - Risk-free rate

Now we can use the weights and costs of equity and debt to calculate the weighted average cost of capital (WACC):

WACC = (Equity weight x Cost of equity) + (Debt weight x Cost of debt x (1 - Tax rate))

0.084 x (1 - 0.36) = 0.05376 (cost of debt after tax)
WACC = (0.35 x 0.137) + (0.65 x 0.05376) = 0.1042, or 10.42%

Therefore, the answer is B.

Brewster's Is Considering a Project That Is Equally as Risky