A firm has a debt-equity ratio of 1.Its cost of equity is 17.4 percent and its pretax cost of debt is 7.2 percent.Assume there are no taxes or other imperfections.What would be its cost of equity if the debt-equity ratio were zero?
A)8.8%
B)10.9%
C)12.3%
D)13.1%
E)11.6%

Question

Quizplus · Accepted Answer

When the debt-equity ratio is zero, the firm is entirely equity-financed. The cost of equity in this case would be the same as the firm's unlevered cost of capital. Using the Modigliani-Miller Proposition II without taxes, the unlevered cost of equity can be calculated as: Cost of Equity = Cost of Debt + (Debt-Equity Ratio * (Cost of Equity - Cost of Debt)). Solving for the unlevered cost of equity gives 12.3%.

A Firm Has a Debt-Equity Ratio of 1