Ace Pharmacy Inc.is a business dealing in pain reduction medication.It has a required return on its assets of 15%.It can borrow in the debt market at 8%.If there are no taxes and M&M's proposition II holds,what is the cost of equity if there is 50% equity financing and 50% debt financing?

Question

Quizplus · Accepted Answer

According to M&M Proposition II, the cost of equity (Ke) is equal to the required return on assets (R) plus a premium for financial risk (Rp) multiplied by the debt-equity ratio (D/E). 
Ke = R + Rp (D/E)
Given: R = 15%, debt-equity ratio is 50:50, and the cost of debt (Kd) is 8%.
Substituting the values, we get:
Ke = 15% + (15% - 8%) x (0.5/0.5)
Ke = 22%
Therefore, the cost of equity is 22%, which is option B.