Gulf Coast Tours currently has a weighted average cost of capital of 11.3 percen

Question

Gulf Coast Tours currently has a weighted average cost of capital of 11.3 percent based on a combination of debt and equity financing. The firm has no preferred stock. The current debt-equity ratio is 0.58 and the aftertax cost of debt is 6.4 percent. The company just hired a new president who is considering eliminating all debt financing. All else constant, what will the firm's cost of capital be if the firm switches to an all-equity firm?

10.45 percent

12.62 percent

12.89 percent

13.37 percent

14.32 percent

Explanation / Answer

Suppose Capital of Gulf Coast is 100 Debt + Equity = 100 Debt to Equity ratio is 0.58 So Debt = 0.58 equity or 0.58 equity + Equity = 100 or 1.58 equity =100 Equity = 100/1.58 Equity = 63.29 Debt = 100 - 63.29 = 36.71 WACC = (Cost of debt x Weight of Debt) + (cost of equity x Weight of Equity) Total Weight 11.3 = (6.4 x 36.71) + (Cost of Equity x 63.29) 100 1130 = 234.944 + (63.29 x Cost of equity) 895.056 = 63.29 x Cost of Equity Cost of Equity = 14.14214 Hence option 14.32 is correct

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