A ﬁrm has a debt-to-equity ratio of 1.20.If it had no debt, its cost of equity would be 15%.Its cost of debt is 10%.What is its cost of equity if there are no taxes or other imperfections?
A)10%
B)15%
C)18%
D)21%
E)None of the above.

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II (without taxes), which states that the cost of equity increases with leverage. The formula is: Cost of Equity = Cost of Equity (unlevered) + Debt-to-Equity Ratio * (Cost of Equity (unlevered) - Cost of Debt). Substituting the given values: 15% + 1.20 * (15% - 10%) = 21%.

A ﬁRm Has a Debt-To-Equity Ratio of 1