If a firm is unlevered and has a cost of equity capital 12% what would the cost of equity be if the firms became levered at 2:1?The expected cost of debt would be 8%.
A) 14.67%.
B) 16.0%.
C) 20.0%.
D) 14.0%.

Question

Quizplus · Accepted Answer

The cost of equity for a levered firm can be calculated using the Modigliani-Miller Proposition II formula: $ r_e = r_0 + (r_0 - r_d) \times \frac{D}{E} $. Here, $ r_0 = 12\% $, $ r_d = 8\% $, and the debt-to-equity ratio $ \frac{D}{E} = 2 $. Plugging in these values, $ r_e = 12\% + (12\% - 8\%) \times 2 = 20\% $.

If a Firm Is Unlevered and Has a Cost of Equity