A firm has zero debt in its capital structure. Its overall cost of capital is 10%. The firm is considering a new capital structure with 60% debt. The interest rate on the debt would be 8%. Assuming there are no taxes its cost of equity capital with the new capital structure would be:
A) 8%
B) 16%
C) 13%
D) 10%
E) None of the above

Question

Quizplus · Accepted Answer

With no taxes, the cost of equity can be calculated using the Modigliani-Miller Proposition II formula: Cost of Equity = Cost of Capital + (Cost of Capital - Cost of Debt) * (Debt/Equity). Here, Cost of Equity = 10% + (10% - 8%) * (60/40) = 13%.

A Firm Has Zero Debt in Its Capital Structure