Bigelow, Inc. has a cost of equity of 13.56% and a pre-tax cost of debt of 7%. The required return on the assets is 11%. What is the firm's debt-equity ratio based on M&M II with no taxes?
A) .60
B) .64
C) .72
D) .75
E) .80

Question

Quizplus · Accepted Answer

The Modigliani-Miller Proposition II (M&M II) without taxes states that the cost of equity (Re) is equal to the required return on assets (Ra) plus the debt-equity ratio (D/E) times the spread between the required return on assets and the cost of debt (Rd). This can be expressed as:$$ Re = Ra + (D/E) \times (Ra - Rd) $$Given that:- $ Re = 13.56\% $ or $ 0.1356 $- $ Ra = 11\% $ or $ 0.11 $- $ Rd = 7\% $ or $ 0.07 $We can rearrange the formula to solve for the debt-equity ratio (D/E):$$ 0.1356 = 0.11 + (D/E) \times (0.11 - 0.07) $$$$ 0.1356 = 0.11 + 0.04(D/E) $$$$ 0.0256 = 0.04(D/E) $$$$ D/E = 0.0256 / 0.04 $$$$ D/E = 0.64 $$Therefore, the firm's debt-equity ratio is 0.64.