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Dorset Ltd is all-equity financed and has a cost of capital of 16 per cent...

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Dorset Ltd is all-equity financed and has a cost of capital of 16 per cent per annum. An observer suggests that Dorset could easily borrow up to 40 per cent of the value of its assets at an interest rate of 10 per cent per annum and achieve a rating for its debt of A+ or better. He argues that replacing 40% of equity with debt would lower the company's cost of capital to 13.12%, and increase the net present value of some projects that were recently rejected. Assuming an effective corporate tax rate of 12%, show how the observer arrived at a cost of capital of 13.12%. Is his argument correct? Give reasons for your

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