A firm has zero debt in its capital structure. Its overall cost of capital is 10 percent. The firm is considering a new capital structure with 60 percent debt. The interest rate on the debt would be 8 percent. Assuming there are no taxes, its cost of equity capital with the new capital structure would be
A)8 percent.
B)16 percent.
C)13 percent.
D)10 percent.

Question

Quizplus · Accepted Answer

With the new capital structure, the firm's overall cost of capital = (cost of equity x proportion of equity) + (cost of debt x proportion of debt)
= (cost of equity x 40%) + (8% x 60%) 
= 0.4(cost of equity) + 4.8%
Since the overall cost of capital is still 10%, we can set up an equation:
0.4(cost of equity) + 4.8% = 10%
0.4(cost of equity) = 5.2%
Cost of equity = 13%

A Firm Has Zero Debt in Its Capital Structure