Ewer Firm 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

In order to calculate the appropriate cost of capital, we need to calculate the weighted average cost of capital (WACC).

Step 1: Calculate the cost of debt 
The bond price is $950, so the net proceeds after flotation costs will be $935. The annual coupon payment is $80 ($1,000 x 8%), and the interest paid to bondholders will be tax-deductible. 
Therefore, the after-tax cost of debt = (80/935) x (1 - 0.34) = 4.99%

Step 2: Calculate the cost of equity 
The before-tax cost of equity is given as 16%. After adjusting for the tax shield of debt, the after-tax cost of equity can be calculated as:

After-tax cost of equity = 16% x (1 - 0.34) = 10.56%

Step 3: Calculate WACC 
Using the optimal capital structure of 60% debt and 40% equity:

WACC = (0.6 x 4.99%) + (0.4 x 10.56%) = 9.97%

Therefore, the appropriate cost of capital to use in analyzing this project is 9.97%.

Ewer Firm Will Finance a Proposed Investment by Issuing New