If a firm is unlevered and has a cost of equity capital of 12%, what would its cost of equity be if its debt-equity ratio became 2? The expected cost of debt is 8%.
A)14.0%
B)14.67%
C)16.0%
D)20.0%
E)None of the above.

Question

Quizplus · Accepted Answer

The cost of equity for a levered firm can be calculated using the Modigliani-Miller Proposition II with taxes, which states that the cost of equity is equal to the cost of equity for an unlevered firm plus the debt-equity ratio times the difference between the cost of equity and the cost of debt. Here, the cost of equity for the levered firm = 12% + 2 * (12% - 8%) = 20%.

If a Firm Is Unlevered and Has a Cost of Equity