Managers are going to borrow to finance 50% of the value of new assets. The rest

Question

Managers are going to borrow to finance 50% of the value of new assets. The rest will be financed with equity. They have decided that the correct discount rate to value the project is the average of the firm's estimated 15% cost of equity and the after tax cost of debt. The pre-tax cost of the firm's debt is the yield to maturity of bonds the firm is going to issue. The terms of the bonds are:

settlement 5/5/2014

maturity 5/5/2024

rate 10%

pr 100

redemption 100

frequency 2

basis 0

These terms are from the EXCEL function "Yield".

The firm's marginal tax rate is 25%.

The discount rate the firm uses should be ?

Please explain how to solve it.

Explanation / Answer

Yield of bond = 10%

WACC = 10%*(1-.25) * .5 + 15%*.5 = 11.25%

Discounting rate to be used = 11.25%

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