Texas GenCo is an electric utility that operates coal-fired generating capacity. Like most electric utilities it maintains a moderately high debt/equity ratio of 2.2, a low equity beta coefficient of 0.72 and an even lower debt beta of just 0.18. Suppose the current riskless rate of interest is 3.25% and the expected return on the S&P 500 market index (taken as the diversified market portfolio) is 8.25%. Assume that the corporate tax rate is 34% and that the corporate tax effect of debt approximates the overall effect of debt on firm market value. What is the current weighted average cost of capital for Texas GenCo? Texas GenCo is contemplating purchasing a coal mine to supply its power plants. Realizing that the risk in the coal mining business is different from electric utility risks, Texas GenCo wants to use the financial data from a comparable coal-mining firm to determine the appropriate discount rate for the vestment. The best available comparable firm, American Coal Corp, has a capital structure with 25% debt. The CAPM beta coefficient on American Coal's equity is 2.65, while the beta for its debt is 0.62. Texas GenCo believes that the fundamental risks inherent in the new venture are identical to the fundamental risks reflected in American Coal Corp's debt and equity returns. However, since the new venture will be a small part of Texas GenCo's overall assets, Texas GenCo intends to use its own leverage ratio to finance the new venture and will be able to borrow at an interest rate just 1.5 percentage points above its current bond yield.
What weighted average cost of capital should Texas GenCo use to evaluate the NPV of the cash flows associated with the coal mining investment?