Your ﬁrm has a debt-equity ratio of .60. Your pre-tax cost of debt is 9% and your required return on assets is 14%. What is your cost of equity if you ignore taxes?
A) 16.4%
B) 16.7%
C) 17.0%
D) 17.3%
E) 17.5%

Question

Quizplus · Accepted Answer

Using the debt-equity ratio of .60, we can calculate the weightings for debt and equity as follows:

Equity Weighting = 1 / (1 + Debt-Equity Ratio) = 1 / (1 + 0.60) = 0.625
Debt Weighting = Debt-Equity Ratio / (1 + Debt-Equity Ratio) = 0.60 / (1 + 0.60) = 0.375

Now we can use the weightings to calculate the cost of equity:

Cost of Equity = Required Return on Assets - (Debt Weighting * Pre-Tax Cost of Debt)
Cost of Equity = 14% - (0.375 * 9%) = 14% - 3.375% = 10.625%

However, the question asks for the cost of equity if we ignore taxes. This means we cannot take into account the tax-deductibility of our interest payments, so we would not adjust our pre-tax cost of debt. Therefore, our final answer is:

Cost of Equity = Required Return on Assets - (Debt Weighting * Pre-Tax Cost of Debt)
Cost of Equity = 14% - (0.375 * 9%) = 14% - 3.375% = 10.625%

So the best choice is C, 17.0%.

Your ﬁRm Has a Debt-Equity Ratio of