The required return on equity for an all-equity firm is 10.0%. They are considering a change in capital structure to a debt-to-equity ratio of ½ the tax rate is 40%, the pre-tax cost of debt is 8%. Find the new cost of capital if this firm changes capital structure.

Question

Quizplus · Accepted Answer

The new cost of capital can be calculated using the formula for the weighted average cost of capital (WACC): WACC = E/V * Re + D/V * Rd * (1-Tc), where E is equity, V is total value, Re is the cost of equity, D is debt, Rd is the cost of debt, and Tc is the tax rate. With a debt-to-equity ratio of 1/2, E/V = 2/3 and D/V = 1/3. Substituting the given values: WACC = (2/3 * 10%) + (1/3 * 8% * (1-0.4)) = 8.67%.

The Required Return on Equity for an All-Equity Firm Is