A firm has a debt-to-equity ratio of .60.Its cost of debt is 8%.Its overall cost of capital is 12%.What is its cost of equity if there are no taxes or other imperfections?
A)10.0%
B)13.5%
C)14.4%
D)18.0%
E)None of the above.

Question

Quizplus · Accepted Answer

We can use the equation for the overall cost of capital:

Overall cost of capital = Cost of equity * (equity proportion) + Cost of debt * (debt proportion)

Given:

Debt-to-equity ratio = 0.60

This implies that equity proportion = 1 / (1 + debt-to-equity ratio) = 1 / (1 + 0.60) = 0.625

And, debt proportion = 1 - equity proportion = 1 - 0.625 = 0.375

Also, cost of debt = 8%

Overall cost of capital = 12%

Substituting the values in the equation:

0.12 = Cost of equity * 0.625 + 0.08 * 0.375

Solving for the cost of equity:

Cost of equity = (0.12 - 0.03) / 0.625 = 0.144 or 14.4%

Therefore, the correct answer is (C) 14.4%.

A Firm Has a Debt-To-Equity Ratio of