Question

Bay Beach Industries wants to maintain their capital structure of 40% debt and 60% equity. The firm's tax rate is 34%. The firm can issue the following securities to finance the investments: bonds, mortgage bonds can be issued at a pre-tax cost of 7.7 percent, debentures can be issued at a pre-tax cost of 6.7 percent, common equity can be financed through retained earnings and new common stock. What is the cost of capital using mortgage bonds and internal equity?

Answer 1

The cost of capital for Bay Beach Industries using mortgage bonds and internal equity is calculated with weighted average cost of capital, factoring in the after-tax cost of debt and the cost of internal equity in their respective proportions.

Step-by-step explanation:

The cost of capital for Bay Beach Industries using mortgage bonds and internal equity while maintaining a capital structure of 40% debt and 60% equity can be calculated using the Weighted Average Cost of Capital (WACC) formula. This cost represents the firm's opportunity cost of making an investment, and it is a critical factor in financial decision-making. To maintain their targeted capital structure, the mix of financing will consist of 40% debt through mortgage bonds and 60% equity through retained earnings.

Mortgage bonds have a pre-tax cost of 7.7%, and to find the after-tax cost, we use the tax rate of 34%: after-tax cost of debt = pre-tax cost of debt * (1 - tax rate) = 7.7% * (1 - 0.34) = 5.082%. Assuming the cost of internal equity remains unchanged, we calculate the overall WACC. The firm's weighted cost of capital would be a combination of the costs of debt and equity at their respective weights: WACC = (40% * after-tax cost of debt) + (60% * cost of internal equity). Since the cost of internal equity is not specified, it cannot be included in the calculation; however, for the sake of the exercise, if the cost of internal equity were known, the overall WACC could be calculated accordingly.