A firm has 2,000,000 shares of common stock outstanding with a market
price of $2.00 per share. It has 2,000 bonds outstanding, each selling
for $1,200. The bonds mature in 15 years, have a coupon rate of 10%,
and pay coupons anually. The firm's beta is 1.2, the risk free rate is
5%, and the market risk premium is 7%. The tax rate is 34%. Calculate
the weighted average cost of capital?
Please show all work.
It is however multiple choice. 
a. 5.42%
b. 6.53%
c. 9.36%
d. 10.28%
e. 11.57%

Pheifer --

It appears that answer (d) should be 10.78% -- not 10.28%.

Here are the details on calculating the weighted-average cost-of-capital (WACC):

Let's start with the capital weights:

EQUITY: $4 million
DEBT: $2.4 million
TOTAL CAPITAL: $6.4 million

Equity: 62.5%
Debt: 37.5%


COST OF EQUITY
-------------------------

Here's how the equity costs are derived:
ValuePro
"The Cost of Equity"
http://www.valuepro.net/approach/equity/equity.shtml

Rerp = Rm - Rf

Rerp = the equity risk premium of stocks
Rm = market returns for a diversified portfolio
Rf = risk-free rate, generally a treasury bill rate

So, the Rerp = 7%

Rs = Rf + B * (Rerp)


Rs = return on a stock
Rf = risk-free (t-bill) rate
B = beta (volatility, measured in the market)
Rerp = the equity risk premium of stocks

Okay, so your cost of equity is:
Rs = 5% + 1.2 * 7%
Rs = 13.4%


COST OF DEBT
-------------

The bonds have a cost of 10% but we have to reduce the debt costs for
the effect of taxes.  After-tax debt costs are:
(1-.34) * 10% = 6.4%


WACC
-----

Now we simply need weight the two per the debt/equity ratio:
.625 * 13.4% + .375 * 6.4% = 8.38% + 2.4% = 10.78%


Google search strategy:
"cost of equity" + beta

Best regards,

Omnivorous-GA