Marion's Miraculous Resorts has a current capital structure that is 50% equity, 40% debt, and 10% preferred stock. This is considered optimal. Marion is considering a $40 million capital budgeting project. Marion has estimated the following: After-tax cost of debt: 8.5%
Cost of preferred stock: 9.5%
Cost of internal equity: 14.0%
If all equity comes from internal sources, what should Marion's cost of capital be for this project?

Question

Quizplus · Accepted Answer

Using the optimal capital structure, we can calculate the weighted average cost of capital (WACC) as follows:

WACC = (Equity/Total Capital) x Cost of Equity + (Debt/Total Capital) x After-tax Cost of Debt + (Preferred Stock/Total Capital) x Cost of Preferred Stock

WACC = (0.50 x 14.0%) + (0.40 x 8.5%) + (0.10 x 9.5%) = 11.35%

Since all equity is coming from internal sources, we don't need to consider the cost of preferred stock or after-tax cost of debt. Therefore, the cost of capital should be equal to the cost of equity, which is 14.0%. However, since the project is financed with the optimal capital structure, we can use the WACC calculated above.

Therefore, the answer is B) 11.35%.

Marion's Miraculous Resorts Has a Current Capital Structure That Is