M&M Proposition 2: Bellamee, Inc., has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Their current debt-to-equity ratio is 1/5. What is the required rate of return on their equity?

Question

Quizplus · Accepted Answer

According to M&M Proposition 2, the required rate of return on equity (Ke) can be calculated using the formula: Ke = Kd + (Kd-Kt) x (D/E), where Kd is the cost of debt, Kt is the corporate tax rate, and D/E is the debt-to-equity ratio. Since the tax rate is not given in the question, we assume it to be zero. Thus, Ke = 6.25% + (6.25% - 0%) x (1/5) = 6.25% + 1.25% = 7.5%. Therefore, the required rate of return on their equity is 12% + 7.5% = 19.5%. But the given options do not include this value. The closest value is 13.15%, which is Option B.