Your ﬁrm has a debt-equity ratio of .60. Your cost of equity is 11% and your after-tax cost of debt is 7%. What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and
Equity?
A) 9.50%
B) 10.50%
C) 11.00%
D) 11.25%
E) 12.00%

Question

Quizplus · Accepted Answer

The cost of equity can be recalculated using the Modigliani-Miller Proposition II with taxes, which states that the cost of equity increases with the debt-equity ratio. With a 50/50 mix, the debt-equity ratio is 1. Using the formula: Cost of Equity = Cost of Equity (unlevered) + (Cost of Equity (unlevered) - Cost of Debt) * (Debt/Equity), the new cost of equity is 12%.

Your ﬁRm Has a Debt-Equity Ratio of