BB is considering moving to a capital structure that is comprised of 20% debt and 80% equity, based on market values. The debt would have an interest rate of 7%. The new funds would be used to repurchase stock. It is estimated that the increase in risk resulting from the additional
Leverage would cause the required rate of return on equity to rise to
14%) If this plan were carried out, what would BB's new value of operations be?

Question

Quizplus · Accepted Answer

The correct answer is A. The new value of operations is $498,339. This is calculated by taking the current value of operations and dividing it by the new cost of capital. The new cost of capital is calculated by taking the weighted average of the cost of debt and the cost of equity. The cost of debt is 7%, and the cost of equity is 14%. The weights are 20% and 80%, respectively. This gives a new cost of capital of 10.6%. The new value of operations is then calculated by dividing the current value of operations by 10.6%.

BB Is Considering Moving to a Capital Structure That Is