If a firm is unlevered and has a cost of equity capital of 13.7 percent,what would be the cost of equity if its debt-equity ratio was revised to .4? The expected cost of debt is 7.4 percent and there are no taxes.
A)15.54 percent
B)15.67 percent
C)16.09 percent
D)16.22 percent
E)16.36 percent

Question

Quizplus · Accepted Answer

Using the formula for levered cost of equity, 
r_E = r_U + (r_U - r_D) * (D/E)
where, 
r_U = 13.7% (Unlevered cost of equity)
r_D = 7.4% (Cost of debt)
D/E = 0.4 (Debt-equity ratio)

Thus, 
r_E = 13.7% + (13.7% - 7.4%) * (0.4)
    = 16.22%
Therefore, the cost of equity capital would be 16.22% if the firm's debt-equity ratio was revised to 0.4.

Hence, the correct answer is option D) 16.22 percent.

If a Firm Is Unlevered and Has a Cost of Equity