A firm has a debt-to-equity ratio of 1. Its levered cost of equity is 16 percent, and its cost of debt is 8 percent. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?

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Quizplus · Accepted Answer

The cost of equity if the debt-to-equity ratio were zero (i.e., the firm is completely equity financed) can be found using the Modigliani-Miller proposition without taxes. The formula for the cost of equity in a levered firm (Re) is Re = Ru + (Ru - Rd) * (D/E), where Ru is the unlevered cost of equity, Rd is the cost of debt, D/E is the debt-to-equity ratio. Given that the firm's levered cost of equity (Re) is 16%, its cost of debt (Rd) is 8%, and its debt-to-equity ratio (D/E) is 1, we can rearrange the formula to solve for Ru (the unlevered cost of equity, which is the cost of equity if the debt-to-equity ratio were zero). Plugging in the given values, we find that Ru = 12%, indicating that the cost of equity if the firm were completely equity financed would be 12 percent.

A Firm Has a Debt-To-Equity Ratio of 1