Alabaster Incorporated wants to be levered at a debt to value ratio of .6. The cost of debt is 9%,the tax rate is 35%,and the cost of equity for an all equity firm is 12%. What will be Alabaster's cost of equity?

Question

Quizplus · Accepted Answer

Using the Modigliani-Miller Proposition II with taxes, the cost of equity can be calculated as: Cost of Equity = Cost of Unlevered Equity + (Debt/Equity) * (Cost of Unlevered Equity - Cost of Debt) * (1 - Tax Rate). Here, the Debt/Equity ratio is 1.5 (since Debt/Value is 0.6, Equity/Value is 0.4, thus Debt/Equity is 0.6/0.4 = 1.5). Plugging in the values: 12% + 1.5 * (12% - 9%) * (1 - 0.35) = 14.93%.

Alabaster Incorporated Wants to Be Levered at a Debt to Value