A firm has zero debt and an overall cost of capital of 13.8 percent.The firm is considering a new capital structure with 40 percent debt.The interest rate on the debt would be 7.2 percent and the corporate tax rate is 21 percent.What would be the cost of equity with the new capital structure?
A)16.90 percent
B)16.11 percent
C)17.28 percent
D)17.34 percent
E)17.59 percent

Question

Quizplus · Accepted Answer

The cost of equity with the new capital structure can be calculated using the Modigliani-Miller Proposition II with taxes:  Re = Ra + (Ra - Rd) * (D/E) * (1 - Tc)  Where:  Re = cost of equity  Ra = overall cost of capital (13.8%)  Rd = cost of debt (7.2%)  D/E = debt-equity ratio (0.4/0.6)  Tc = corporate tax rate (21%)  Re = 13.8% + (13.8% - 7.2%) * (0.4/0.6) * (1 - 0.21)  Re = 13.8% + 6.6% * 0.6667 * 0.79  Re = 13.8% + 3.48%  Re = 17.28%

A Firm Has Zero Debt and an Overall Cost of Capital