ABC, Inc. has a debt/equity ratio = 1.2. The firm has a cost of equity of 12% and a cost of debt of 8%. What will the cost of equity be if the target debt/equity ratio increases to 2.0 and the cost of debt does not change? Ignore taxes.

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Quizplus · Accepted Answer

The cost of equity increases with leverage due to the increased financial risk. The Modigliani and Miller proposition without taxes suggests that the cost of equity is a linear function of the company's debt/equity ratio. Given the initial cost of equity (12%) at a debt/equity ratio of 1.2, and the cost of debt remains constant at 8%, when the debt/equity ratio increases to 2.0, the cost of equity will increase because the financial risk to equity holders increases as the firm takes on more debt. The exact calculation requires the application of the formula for the levered cost of equity (ke = ku + (ku - kd) * (D/E)), where ku is the unlevered cost of equity, kd is the cost of debt, and D/E is the debt-to-equity ratio. However, without the unlevered cost of equity, a direct calculation isn't provided here, but the principle that the cost of equity increases with leverage due to increased financial risk leads to the conclusion that the cost of equity will be higher than the initial 12%, with 13.46% being the correct choice given the options.

ABC, Inc Has a Debt/equity Ratio = 1