A firm has a debt-to-equity ratio of 1.75. If it had no debt, its cost of equity would be 9%. Its cost of debt is 7%. What is its cost of equity if the corporate tax rate is 50%?
A) 10.0%.
B) 10.75%.
C) 12.50%.
D) 7.73%.

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes. The formula is: Cost of Equity = Cost of Equity if Unlevered + (Debt/Equity) * (Cost of Equity if Unlevered - Cost of Debt) * (1 - Tax Rate). Plugging in the numbers: 9% + (1.75) * (9% - 7%) * (1 - 0.5) = 9% + 1.75 * 2% * 0.5 = 9% + 1.75%. Therefore, the cost of equity is 10.75%.

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