A firm uses only debt and equity in its capital structure. The firm's weight of debt is 75 percent. The firm could issue new bonds at a yield to maturity of 12 percent and the firm has a tax rate of 30 percent. If the firm's WACC is 13 percent, what is the firm's cost of equity?
A)38.29 percent
B)36.00 percent
C)26.80 percent
D)4.00 percent

Question

Quizplus · Accepted Answer

First, we need to calculate the firm's cost of debt:

After-tax cost of debt = Yield to maturity * (1 - Tax rate)
After-tax cost of debt = 0.12 * (1 - 0.30)
After-tax cost of debt = 0.084 or 8.4%

Next, we can use the WACC equation to solve for the cost of equity:

WACC = (Weight of debt * After-tax cost of debt) + (Weight of equity * Cost of equity)
0.13 = (0.75 * 0.084) + (0.25 * Cost of equity)
0.13 - (0.75 * 0.084) = 0.25 * Cost of equity
0.0645 = 0.25 * Cost of equity
Cost of equity = 0.258 or 25.8%

Therefore, the firm's cost of equity is 26.80% (rounded to two decimal places). The answer is C).

A Firm Uses Only Debt and Equity in Its Capital