Cromwell's Interiors is considering a project that is equally as risky as the firm's current operations. The firm has a cost of equity of 15.4 percent and a pretax cost of debt of 8.9 percent. The debt-equity ratio is .46 and the tax rate is 34 percent. What is the cost of capital for this project?A) 11.97 percentB) 12.40 percentC) 11.02 percentD) 11.62 percentE) 12.38 percent

Cost of capital = 12.40% (Approx)

Explanation:

Given:

Cost of equity =  15.4%

Pretax cost of debt = 8.9%

Debt-equity ratio = 0.46

Tax rate = 34%

Computation:

Equity multiplier = 1 + Debt-equity ratio

Equity multiplier = 1 + 0.46

Equity multiplier = 1.46

Weight of equity = 1 / Equity multiplier

Weight of equity = 1 / 1.46

Weight of equity = 0.685

Weight of Debt = 1 - Weight of equity

Weight of Debt = 1 - 0.685

Weight of Debt = 0.315

Cost of capital = [Weight of Debt x Pretax cost of debt] x (1-tax rate) + [Cost of equity x Weight of Debt ]

Cost of capital = [0.315 x 8.9% x (1-0.34)] + [15.4% x 0.6849]

Cost of capital = 12.40% (Approx)

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