Your firm has a debt-equity ratio of .60.Your cost of equity is 11% and your after-tax cost of debt is 7%.What will your cost of equity be if the target capital
Structure becomes a 50/50 mix of debt and equity?
A)9.50%
B)10.50%
C)11.00%
D)11.25%
E)12.00%

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes, which states that the cost of equity increases with the debt-equity ratio. When the firm changes its capital structure to a 50/50 mix, the debt-equity ratio becomes 1. Using the formula: Cost of Equity = Cost of Equity (unlevered) + (Cost of Equity (unlevered) - Cost of Debt) * (Debt/Equity), we find that the cost of equity increases to 12%.

Your Firm Has a Debt-Equity Ratio of