Flyover Airlines Inc.has a cost of equity equal to 24.67%.If the firm is financed with 40% debt and 60% equity and has an average cost of capital of 18%,what is the cost of debt? Assume perfect capital markets.
A)8.00%
B)6.67%
C)10.00%
D)12.33%

Question

Quizplus · Accepted Answer

The cost of debt can be calculated using the Weighted Average Cost of Capital (WACC) formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E is the market value of the equity, D is the market value of the debt, V = E + D (the total market value of the firm's financing), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate. In a perfect capital market (assuming no taxes), the formula simplifies to WACC = (E/V) * Re + (D/V) * Rd. Given that the firm's WACC is 18%, the cost of equity is 24.67%, the firm is financed with 40% debt, and 60% equity, we can set up the equation: 18% = (60% * 24.67%) + (40% * Rd). Solving for Rd gives us 8.00%.