Use the information for the question(s)below.
Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy,with each outcome being equally likely.The initial investment required for the project is $80,000,and the project's cost of capital is 15%.The risk-free interest rate is 5%.
-Suppose that you borrow $30,000 in financing the project.According to MM proposition II,the firm's equity cost of capital will be closest to:
A)21%.
B)15%.
C)20%.
D)25%.

Question

Quizplus · Accepted Answer

According to MM proposition II, the firm's equity cost of capital is given by:

Re = R0 + (R0 - Rd) x (D/E)

where, 
Re = Equity cost of capital
R0 = Cost of capital with no debt
Rd = Cost of debt
D/E = Debt-to-equity ratio

In this case, D/E = $30,000 / ($80,000 - $30,000) = 0.6

Also, R0 = (0.5 x $90,000 + 0.5 x $117,000 - $80,000) / $80,000 x 100% = 20.625%

Since the risk-free interest rate is 5%, Rd = 5%

Therefore, 
Re = 20.625% + (20.625% - 5%) x 0.6 = 20%

Hence, the closest answer choice is (C) 20%.

Use the Information for the Question(s)below