Gulf Coast Tours currently has a weighted average cost of capital of 11.3 percent based on a combination of debt and equity financing. The firm has no preferred stock. The current debt-equity ratio is 0.58 and the aftertax cost of debt is 6.4 percent. The company just hired a new president who is considering eliminating all debt financing. All else constant, what will the firm's cost of capital be if the firm switches to an all-equity firm. A 10.45 percent B. 12.62 percentC 12.89 percent D. 13.37 percent

The correct answer is 14.14% even though it is not in the choices.

Explanation:

Use weighted average cost of capital WACC formula to calculate the cost of equity;

WACC = wE*rE + wD*rD (1-tax)

wE = weight of equity

re = cost of equity

wD = weight of debt

rD (1-tax) = aftertax cost of debt

D/E = 0.58/1 meaning debt = 0.58 and equity = 1

and total capital; D+E = 0.58+1 = 1.58, so

wE = 1 / 1.58 = 0.6329

wD = 0.58 / 1.58 = 0.3671

Next, plug in the numbers (as decimals) to the WACC formula;

0.113 = (0.6329 * rE) + (0.3671 * 0.064)

0.113 = 0.6329rE + 0.0235

Subtract 0.0235 from both sides;

0.113 - 0.0235 = 0.6329rE

0.0895 = 0.6329rE

rE = 0.0895 / 0.6329

rE = 0.1414 or 14.14%

Cost of equity is 14.14%