Question 3: Cost of Capital

Cost of capital is often a significant component affecting the expected returns. If the cost of capital is high, then the expected returns demanded of an investment may be more than it can provide, making the project unattractive. The cost of capital can be calculated using a weighted average of the cost of debt and the cost of equity according to the following equation:

COC = C_d*R_d + C_e*R_e

Where:

C_d is the cost of debt

C_e is the cost of equity

R_d is the ratio of debt to total assets that is equal to the debt/equity leverage ratio (L) divided by 1+L

R_d = L/(1+L)

R_e is the ratio of equity to total assets, and is equal to 1-R_d

R_e = 1-R_d

An investor has $2.3 million in debt and $1.7 million in equity. They find that their cost of equity is 10.2% and the cost of debt, based on existing loans, is 3.4%. What is their cost of capital?