A firm has a market value of assets of $50,000. It borrows $10,000 at 3%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

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Quizplus · Accepted Answer

The firm's cost of equity capital can be calculated using the Modigliani-Miller Proposition II with taxes, which states that the cost of equity increases with leverage. The formula is: Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (Debt/Equity). Here, Debt = $10,000, Equity = $40,000 (since total assets are $50,000 and debt is $10,000), Unlevered Cost of Equity = 15%, and Cost of Debt = 3%. Plugging these values into the formula gives a cost of equity of 18%.

A Firm Has a Market Value of Assets of $50,000