Faraday Enterprises is a publicly traded company. It currently has 10 million shares trading at $12/share and $150 million in book value of equity. The firm also has book value of debt of $ 75 million and market value of debt of $ 80 million. The cost of equity for the company is 9%, the pre-tax cost of debt is 4% and the marginal tax rate is 40%. What is the cost of capital?

6.36%

Explanation:

First we calculate the market value weights of debt and equity,

Debt to the capital ratio is calculated as,

80,000,000/(120,000,000+80,000,000) = 40%.

Therefore Equity ratio will be: (100%-40%) = 60%.

Now,

Cost of capital = (0.6*9%) + (0.4*4%)(1 - 40%) = 6.36%.

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6.36%

Explanation:

Weighted Average Cost of Capital (WACC) is the minimum return that is expected from a project.It shows the risk of the company

WACC = Cost of Equity + Cost of Debt

Capital Source   Market Value        Weight         Cost        Total Cost

Equity                $120,000,000           60%            9%             5.40%

Debt                   $80,000,000           40%          2.40%          0.96%

Total                 $200,000,000         100%                               6.36%

Cost of Debt = Market Interest rate × ( 1 - tax rate)

                     = 4 % × (1 - 0.40)

                     = 2.40%

Therefore,  cost of capital is 6.36%

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