A firm has zero debt in its capital structure. Its overall cost of capital is 9%. The firm is considering a new capital structure with 40% debt. The interest rate on the debt would be 4%. Assuming that the corporate tax rate is 34%,what would the cost of equity capital with the new capital structure be?
A) 10.3%
B) 11.0%
C) 11.2%
D) 13.9%
E) None of these.

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes: Re = Ra + (Ra - Rd) * (D/E) * (1 - Tc). Here, Ra = 9%, Rd = 4%, D/E = 0.4/0.6, Tc = 34%. Solving gives Re = 11.2%.

A Firm Has Zero Debt in Its Capital Structure