Exley's Farms has a debt-equity ratio of.75. The cost of equity is 15% and the after-tax cost of debt is 5.4%. What will the firm's cost of equity be if the debt-equity ratio is revised to.60?

Question

Quizplus · Accepted Answer

The firm's cost of equity increases when the debt-equity ratio decreases because the firm is using less debt, which is cheaper than equity due to the tax shield on interest payments. The cost of equity can be calculated using the Modigliani-Miller proposition with taxes, which considers the cost of equity as a function of the unlevered cost of equity, the debt-equity ratio, and the after-tax cost of debt. However, without the unlevered cost of equity or the firm's beta, we cannot directly calculate the new cost of equity from the given information. The correct answer is inferred based on the understanding that as the firm reduces its leverage (debt-equity ratio), the cost of equity increases due to the decreased tax shield from debt and the increased reliance on equity financing, which is more expensive than debt financing.

Exley's Farms Has a Debt-Equity Ratio Of