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The Beta Corporation has an optimal debt ratio of 40%. Its cost of equity capital is 12% and its before-tax borrowing rate is 8%. Given a marginal tax rate of 35%, calculate
(1) The weighted-average cost of capital and,
(2) The cost of equity for an equivalent all-equity financed firm.
Solution:
(1) K = (1 - .40).12 + (.40).08(1 - .35)
= .0928 or 9.28%
(2) A weighted-average cost of capital of 9.28% for a levered firm implies:
K =.0928 = Ku (1-(.35)(.40)). Solving for Ku yields .1079 or 10.79%.
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