A firm has a debt-to-equity ratio of 1.20. If it had no debt, its cost of equity would be 15%. Its cost of debt is 10%. What is its cost of equity if there are no taxes or other imperfections?
A) 21%.
B) 18%.
C) 15%.
D) 10%.

Question

Quizplus · Accepted Answer

The cost of equity increases with leverage due to the increased risk to equity holders. The Modigliani-Miller proposition without taxes (Proposition II) provides the formula to calculate the levered cost of equity (Re) as follows: Re = Ru + (Ru - Rd) * (D/E), where Ru is the unlevered cost of equity, Rd is the cost of debt, and D/E is the debt-to-equity ratio. Substituting the given values: Re = 15% + (15% - 10%) * 1.20 = 15% + 6% = 21%.

A Firm Has a Debt-To-Equity Ratio of 1