James Bay Water Park operates in a world with 15% taxes and no financial distress.The firm has a debt/equity ratio of 1.The cost of equity to James Bay Water Park is 20% and the cost of debt is 8%.The only difference between Whispering Pines Resort and James Bay Water Park is that Whispering Pines Resort has a debt/equity ratio of 2.What is the cost of equity for Whispering Pines Resort?
A)25.52%
B)11.20%
C)13.40%
D)14.49%

Question

Quizplus · Accepted Answer

Using the Modigliani-Miller Proposition II with taxes, the cost of equity can be calculated using the formula: $ r_E = r_0 + (r_0 - r_D)(1 - T_C)D/E $, where $ r_E $ is the cost of equity, $ r_0 $ is the cost of capital, $ r_D $ is the cost of debt, $ T_C $ is the tax rate, and $ D/E $ is the debt-to-equity ratio. For James Bay Water Park, we can first find $ r_0 $ using its given data. Given that James Bay has a debt/equity ratio of 1, its cost of equity is 20%, its cost of debt is 8%, and the tax rate is 15%, we can rearrange the formula to solve for $ r_0 $. For Whispering Pines Resort, with a debt/equity ratio of 2, we can then calculate its cost of equity using the same formula and the $ r_0 $ found from James Bay's data. The calculation shows that the cost of equity for Whispering Pines Resort is 25.52%.

James Bay Water Park Operates in a World with 15