Longmont Inc. has a cost of equity of 12% and a pre-tax cost of debt of 6%. The required return on the assets is 10%. What is the firm's debt-equity ratio based on MM Proposition II with no taxes?
A) .45
B) .50
C) .55
D) .60
E) .65

Question

Quizplus · Accepted Answer

According to MM Proposition II with no taxes, the cost of equity is equal to the required return on assets plus the debt-equity ratio times the difference between the required return on assets and the pre-tax cost of debt. Solving the equation 12% = 10% + (10% - 6%) * (D/E) gives a debt-equity ratio of 0.50.