A firm has zero debt in its capital structure and has an overall cost of capital of 10 percent.The firm is considering a new capital structure with 60 percent debt at an interest rate of 8 percent.Assuming there are no taxes or other imperfections,what would be the cost of equity with the new capital structure?
A)9 percent
B)10 percent
C)13 percent
D)14 percent
E)11 percent

Question

Quizplus · Accepted Answer

The cost of capital formula is:

Cost of Capital (WACC) = (Cost of Equity x % Equity) + (Cost of Debt x % Debt)

Since the firm has zero debt in its current capital structure, the cost of equity is equal to the overall cost of capital of 10 percent.

In the new capital structure, the cost of debt is 8 percent and the percent of debt is 60 percent, so the percent of equity is 40 percent.

Plugging in the numbers:

10% = (Cost of Equity x 100%) + (8% x 60%) 
10% = Cost of Equity + 4.8% 
Cost of Equity = 5.2% + 10% 
Cost of Equity = 13%

Therefore, the answer is C) 13 percent.

A Firm Has Zero Debt in Its Capital Structure and Has