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The market value of Charcoal Corporation's common stock is $20 million, and the market value of its risk-free debt is $5 million. The beta of the company's common stock is 1.25, and the market risk premium is 8%. If the Treasury bill rate is 5%, what is the company's cost of capital? (Assume no taxes.)

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Answer:

The company's cost of capital is 8%

Explanation:

With the given information, we can calculate company's cost of equity by Capital Asset Pricing Model (CAPM) = risk free rate of return + beta * (market rate of return – risk free rate of return), in which risk free rate of return  is Treasur bill rate which is backed up by government then free risk

Cost of equity (CAPM) = 5% + 1.25*(8%-5%) = 8.75%

Cost of debt = interest rate of debt * (1 – tax rate) = 5%*(1-0) = 5%

Cost of capital = cost of debt * its portion in total debt & equity + cost of equital * its portion in total debt & equity

= 5%*($5 million/ $25 million)+ 8.75% * ($20 million/ $25 million) = 8%