A ﬁrm has a debt-to-equity ratio of 1.75.If it had no debt, its cost of equity would be 14%.Its cost of debt is 10%.What is its cost of equity if the corporate tax rate is 30%?
A)14.0%
B)16.0%
C)18.9%
D)21.0%
E)None of the above.

Question

Quizplus · Accepted Answer

First, we need to calculate the unlevered cost of equity using the following formula:

Unlevered Cost of Equity = Cost of Equity + ((Cost of Equity - Cost of Debt) x (1 - Tax Rate))

Unlevered Cost of Equity = 14% + ((14% - 10%) x (1 - 0.30))

Unlevered Cost of Equity = 14% + (4% x 0.70)

Unlevered Cost of Equity = 16.8%

Next, we can use the debt-to-equity ratio to calculate the levered cost of equity using the following formula:

Levered Cost of Equity = Unlevered Cost of Equity + (Debt-to-Equity Ratio x (Unlevered Cost of Equity - Cost of Debt) x (1 - Tax Rate))

Levered Cost of Equity = 16.8% + (1.75 x (16.8% - 10%) x (1 - 0.30))

Levered Cost of Equity = 18.9%

Therefore, the answer is (C).

A ﬁRm Has a Debt-To-Equity Ratio of 1