The required return on equity for a levered firm is 10.60 percent.The debt to equity ratio is 1/2,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.

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Quizplus · Accepted Answer

The cost of capital if the firm were financed entirely with equity can be found using the Modigliani-Miller Proposition II without taxes formula: $r_E = r_A + (r_A - r_D)(D/E)$, where $r_E$ is the cost of equity, $r_A$ is the cost of capital, and $r_D$ is the cost of debt. However, given the information, we can rearrange the formula to solve for $r_A$ (the cost of capital if the firm were all equity financed) since we know $r_E$ (10.60%), $D/E$ (1/2), and $r_D$ (8%). The tax shield is not directly used in this calculation because we're looking for the unlevered cost of capital, but it affects the levered cost of equity which we are given. Solving for $r_A$ gives us approximately 10%, indicating that the cost of capital if the firm were financed entirely with equity would be 10 percent.

The Required Return on Equity for a Levered Firm Is