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.)

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%