The Corner Bakery has a debt-equity ratio of .53. The required return on assets is 13.5 percent and its cost of equity is 15.8 percent. What is the pretax cost of debt based on M&M Proposition II with no taxes?
A) 8.78 percent
B) 10.68 percent
C) 9.16 percent
D) 7.56 percent
E) 8.40 percent

Question

Quizplus · Accepted Answer

According to M&M Proposition II with no taxes, the cost of equity and the cost of capital are related as:

Cost of capital = Cost of equity + (Cost of equity - Cost of debt) x (Debt/Equity)

0.135 = 0.158 + (0.158 - Cost of debt) x (0.53/0.47)

Solving for the cost of debt gives:

Cost of debt = 0.0916 or 9.16%

The Corner Bakery Has a Debt-Equity Ratio of