Jen and Barry's Ice Cream needs $20 million in new capital to expand its production facilities. It will use 40% debt and 60% equity. The company's after-tax cost of debt is 5% and the cost of equity is 12.5%. Flotation costs will be 3% for debt and 9% for equity. What rate should be used to discount the cash flows from the expansion project?

Question

Quizplus · Accepted Answer

To calculate the weighted average cost of capital (WACC), we need to use the following formula:

WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc)

Where:
E = market value of the firm's equity
D = market value of the firm's debt
V = total value of the firm (E + D)
Re = cost of equity
Rd = cost of debt
Tc = corporate tax rate

First, we need to calculate the market value of the firm's equity and debt:

Equity = 60% x $20 million = $12 million
Debt = 40% x $20 million = $8 million

Next, we need to adjust the cost of debt for flotation costs:

Rd = 5% x (1 - 0.03) = 4.85%

We can now calculate WACC:

WACC = (12/20) x 12.5% + (8/20) x 4.85% x (1 - 0) = 9.5%

Therefore, the rate that should be used to discount the cash flows from the expansion project is 9.5%. Answer choice C is the best choice.

Jen and Barry's Ice Cream Needs $20 Million in New