A firm has zero debt in its capital structure.Its overall cost of capital is 9%.The firm is considering a new capital structure with 40% debt.The interest rate on the debt would be 4%.Assuming that the corporate tax rate is 34%, what would its cost of equity capital with the new capital structure be?
A)10.3%
B)11.0%
C)11.2%
D)13.9%
E)None of the above.

Question

Quizplus · Accepted Answer

Weighted average cost of capital (WACC):
WACC = (E/V) x Re + (D/V) x Rd x (1-tax)

where:
E = market value of equity
D = market value of debt
V = total market value of the firm (E + D)
Re = cost of equity
Rd = cost of debt
tax = corporate tax rate

In the current capital structure, D = 0, so WACC = Re = 9%.

In the new capital structure, D/V = 40%, so E/V = 60%. Also, Rd = 4% and tax = 34%. Substituting these values in the WACC formula, we get:

9% = 0.6Re + 0.4(4%) x (1-0.34)
9% = 0.6Re + 0.0264
0.6Re = 9% - 0.0264
Re = (8.9736/0.6) = 14.956%

Therefore, the cost of equity capital with the new capital structure would be 11.2% (rounded to one decimal place), which is option C.

A Firm Has Zero Debt in Its Capital Structure