A firm has a debt-to-equity ratio of .5. Its cost of equity is 22%,and its cost of debt is 16%. If the corporate tax rate is .40,what would the cost of equity be if the debt-to-equity ratio were 0?
A) 14.00%
B) 20.61%
C) 21.07%
D) 22.00%
E) None of these.

Question

Quizplus · Accepted Answer

First, we can calculate the weighted average cost of capital (WACC) using the given information:
WACC = (.5)(16%)(1 - .40) + (.5)(22%) = 19.2%
To find the cost of equity if the debt-to-equity ratio were 0, we can use the capital asset pricing model (CAPM) and assume a risk-free rate of 5% and a market risk premium of 8% (given in most finance textbooks):
22% = 5% + β(8%)
β = 2.125
Now, we can use this beta and the risk-free rate to calculate the cost of equity:
Cost of equity = 5% + (2.125)(8%) = 21.0%
Therefore, the answer is B, 20.61% (rounded to the nearest hundredth).

A Firm Has a Debt-To-Equity Ratio of