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 or other imperfections, its cost of equity capital with the new capital structure would be:
A) 9%.
B) 14%.
C) 13%.
D) 10%.

Question

Quizplus · Accepted Answer

The correct answer is C.The cost of equity capital with the new capital structure can be calculated using the weighted average cost of capital (WACC) formula:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)where:E = market value of equityV = total value of the firmRe = cost of equity capitalD = market value of debtRd = cost of debtTc = corporate tax rateIn this case, the firm has zero debt, so the WACC is equal to the cost of equity capital:WACC = ReThe firm is considering a new capital structure with 60% debt. The interest rate on the debt would be 8%. The new WACC can be calculated as follows:WACC = (0.4 * 8%) + (0.6 * 10%) = 9.2%The cost of equity capital with the new capital structure can be calculated as follows:Re = WACC - (D/V) * Rd * (1 - Tc)Re = 9.2% - (0.6 * 8%) * (1 - 0) = 13%Therefore, the cost of equity capital with the new capital structure would be 13%.

A Firm Has Zero Debt in Its Capital Structure