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Rockwood Enterprises is currently an all-equity firm and has just announced plans to expand their current business.In order to fund this expansion,Rockwood will need to raise $100 million in new capital.After the expansion,Rockwood is expected to produce earnings before interest and taxes of $50 million per year in perpetuity.Rockwood has already announced the planned expansion,but has not yet determined how best to fund the expansion.Rockwood currently has 16 million shares outstanding and following the expansion announcement these shares are trading at $25 per share.Rockwood has the ability to borrow at a rate of 5% or to issue new equity at $25 per share.
-If Rockwood finances their expansion by issuing $100 million in debt at 5%,what will Rockwood's cost of equity capital be?
A)11.25%
B)10.70%
C)12.50%
D)12.00%

Question

Quizplus · Accepted Answer

The cost of equity capital can be calculated using the Modigliani-Miller Proposition II with taxes, which states that the cost of equity increases with leverage. The formula is: Cost of Equity = Cost of Unlevered Equity + (Debt/Equity) * (Cost of Unlevered Equity - Cost of Debt). Given the earnings before interest and taxes (EBIT) and the debt interest, we can calculate the new cost of equity.

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