Blammo, Inc. has a target capital structure of 30% debt and 70% equity. The firm is planning to invest in a project that will necessitate raising new capital. New debt will be issued at a before-tax yield of 14%, with a coupon rate of 10%. The equity will be provided by internally generated funds so no new outside equity will be issued. If the required rate of return on the firm's stock is 22% and its marginal tax rate is 35%, compute the firm's cost of capital. A) 18.00%B) 18.13%C) 19.68%D) 15.55%

option (B) 18.13%

Explanation:

Given:

Cost of debt = 30%

Cost of equity = 70%

New debt will be issued at a before-tax yield = 14%

coupon rate = 10%

Required rate of return on the firm's stock = 22%

marginal tax rate = 35%

Now,

the firm's cost of capital is calculated as:

= (Cost of Debt * (1-Tax Rate) * Weight of Debt) + (Cost of Equity * Required rate of return on stocks) * 100%

on substituting the respective values, we get

= 30% * (1-0.35) * 14% + (70% * 22%)

or

= (0.3 * 0.65 * 0.14 + 0.7 * 0.22) * 100%

or

the firm's cost of capital = 18.13%

hence, the correct answer is option (B) 18.13%