Cayo Company is financed entirely by common stock which is priced to offer a 10% return.If the company repurchases 40% of the stock and substitutes an equal value of debt costing 7%, what is the cost on the common stock after repurchasing?
A)10%
B)18%
C)12%
D)None of the above

Question

Quizplus · Accepted Answer

When a company repurchases stock and replaces it with debt, the cost of equity increases due to the increased financial risk. The new cost of equity can be calculated using the formula: New Cost of Equity = Old Cost of Equity + (Old Cost of Equity - Cost of Debt) * (Debt/Equity). Here, it becomes 10% + (10% - 7%) * (40%/60%) = 12%.

Cayo Company Is Financed Entirely by Common Stock Which Is