A firm has a market value of assets of $50,000. It borrows $10,000 at 5%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?

Question

Quizplus · Accepted Answer

To find the cost of equity, we need to use the formula: Cost of Equity = Unlevered Cost of Equity + (Debt-to-Equity Ratio x (Unlevered Cost of Equity - After-Tax Cost of Debt)).

First, we need to calculate the debt-to-equity ratio, which is Debt / (Debt + Equity) = $10,000 / ($10,000 + $40,000) = 0.2.

Next, we need to calculate the after-tax cost of debt, which is 5% x (1 - tax rate). Assuming a 40% tax rate, the after-tax cost of debt is 3%.

Plugging in all the values, we get Cost of Equity = 15% + (0.2 x (15% - 3%)) = 17.5%. Therefore, the answer is B) 17.5%.

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