A firm has a debt-to-equity ratio of 1.75. If it had no debt,its cost of equity would be 14%. Its cost of debt is 10%. What is its cost of equity if the corporate tax rate is 50%?
A) 14.0%
B) 16.0%
C) 17.5%
D) 21.0%
E) None of these.

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes: Cost of Equity = Cost of Unlevered Equity + (Debt/Equity) * (1 - Tax Rate) * (Cost of Unlevered Equity - Cost of Debt). Plugging in the values: 14% + 1.75 * (1 - 0.5) * (14% - 10%) = 17.5%.

A Firm Has a Debt-To-Equity Ratio of 1