The required return on equity for a levered firm is 10.60 percent.The debt to equity ratio is ½ the tax rate is 40 percent,the pre-tax cost of debt is 8 percent.Find the cost of capital if this firm were financed entirely with equity.

Question

Quizplus · Accepted Answer

First, we need to use the following formula to calculate the cost of capital for a levered firm:

Cost of Equity = Required Return on Equity + ((Required Return on Equity - Pre-tax Cost of Debt) x (1 - Tax Rate) x (Debt/Equity))

Given:
- Required Return on Equity = 10.60%
- Debt to Equity ratio = 1/2
- Tax Rate = 40%
- Pre-tax Cost of Debt = 8%

We can calculate the cost of equity as follows:

Cost of Equity = 10.60% + ((10.60% - 8%) x (1 - 0.40) x (1/2))
Cost of Equity = 10.60% + (2.16% x 0.5)
Cost of Equity = 11.68%

This means that if the firm were financed entirely with equity, the cost of capital would be equal to the cost of equity, which is 11.68%. However, this is not one of the answer choices.

To determine the closest answer choice, we can estimate the cost of equity assuming no debt in the capital structure. This is simply the required return on equity, which is 10.60%. Therefore, the closest answer choice is A) 10 percent.

The Required Return on Equity for a Levered Firm Is