Your firm has a debt-equity ratio of .60. Your cost of equity is 11% and your after-tax cost of debt is 7%. What will your cost of equity be if the target capital structure becomes a 50/50 mix of debt and equity?
A) 9.50%
B) 10.50%
C) 11.00%
D) 11.25%
E) 12.00%

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes, which states that the cost of equity increases with leverage. With a 50/50 debt-equity ratio, the cost of equity will be higher than the initial 11% due to increased financial risk.

Your Firm Has a Debt-Equity Ratio of