Kinder Morgan, an oil and gas pipeline company, is contemplating the expansion of its TransMountain Pipeline, which runs from Alberta to the British Columbia coast. The project is estimated to cost $7.4 billion and is expected to have a useful life of 15 years, with a salvage value of $0.5 billion. The new equipment will be added to an existing CCA Class with a rate of 5%. The pipeline expansion will increase capacity from the current level of 300,000 barrels per day to 890,000 barrels per day (assume 365 days/year). Kinder Morgan has signed contracts with Alberta's major oil producers and will charge an average rate of $3.50 per barrel in the first year, and this rate will increase at a projected rate of 3% per year for future years. Variable costs are estimated to be 25% of the sales price. Fixed costs are $50 million per year and they are also expected to increase at a rate of 3% per year. It is also expected that the pipeline expansion will require an immediate investment in inventories of $15 million, accounts receivable of $10 million, and in accounts payable of $20 million. At the end of the expansion's useful life, working capital will be reduced by $5 million. It is expected that Kinder Morgan will finance this project with 75% debt and the remainder with equity (e.g. new common shares). It is expecting to issue new debt with a maturity equal to the useful life of the project, with an annual coupon rate of 7% (coupons paid semi-annually), and it is projected to sell for 101% of par. Flotation costs on the new debt are expected to be 1.5%. It is expected that the new equity will have a systematic risk component based on its exposure to the S&P/TSX index beta of 0.85, and that the appropriate risk-free rate is expected to be 2%. The return on the S&P/TSX Index is 8.5%, Flotation costs on new equity are expected to be 2.5%. Kinder Morgan falls into the 34% corporate tax bracket.

1. What is the pre-tax cost of debt?

2. What is the cost of capital for equity?