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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 $60,000 in financing the project.According to MM proposition II,the firm's equity cost of capital will be closest to:
A)45%.
B)30%.
C)25%.
D)35%.

Question

Quizplus · Accepted Answer

According to MM Proposition II, the equity cost of capital can be calculated using the formula: Re = Ra + (Ra - Rd) * (D/E), where Ra is the project's cost of capital (15%), Rd is the cost of debt (risk-free rate, 5%), D is the debt ($60,000), and E is the equity ($20,000). Plugging in these values gives Re = 15% + (15% - 5%) * (60,000/20,000) = 35%.

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