A firm has a debt-to-equity ratio of 0.5. Its cost of equity is 22%, and its cost of debt is
16%) If the corporate tax rate is .40, what would its cost of equity be if the debt-to-equity ratio were 0?
A) 20.62%
B) 16.00%
C) 26.8%
D) None of the above

Question

Quizplus · Accepted Answer

The cost of equity with a debt-to-equity ratio of 0 can be calculated using the Modigliani-Miller Proposition II (without taxes), which states that the cost of equity is equal to the cost of capital when there is no debt. Here, the cost of equity would be the same as the current cost of equity, adjusted for the tax shield, which is 22%.

A Firm Has a Debt-To-Equity Ratio of 0