A firm has zero debt in its capital structure. Its overall cost of capital is 10%. The firm is considering a new capital structure with 60% debt. The interest rate on the debt would be 8%. Assuming there are no taxes or other imperfections,its cost of equity capital with the new capital structure would be _____.
A) 9%
B) 10%
C) 13%
D) 14%
E) None of these.

Question

Quizplus · Accepted Answer

With the new capital structure of 60% debt and 40% equity, the cost of equity capital can be calculated as follows:

Cost of Equity = Overall Cost of Capital - (Weight of Debt x Cost of Debt)

Weight of Debt = 60%
Cost of Debt = 8%
Overall Cost of Capital = 10%

Cost of Equity = 10% - (0.6 × 8%) = 10% - 4.8% = 5.2%

Cost of Equity = 5.2% ÷ 0.4 = 13%

Therefore, the cost of equity capital with the new capital structure of 60% debt would be 13%.

A Firm Has Zero Debt in Its Capital Structure