A firm has a market value of assets of $50 000. It borrows $10 000 at 7%. If the unlevered cost of equity is 15%, what is the firm's cost of equity capital?
A)18%
B)19%
C)16%
D)17%

Question

Quizplus · Accepted Answer

The firm's cost of equity capital can be calculated using the Modigliani-Miller Proposition II with taxes, which states that the cost of equity increases with leverage. The formula is: Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (Debt/Equity). Here, the equity value is $40,000 ($50,000 - $10,000), so the cost of equity is 15% + (15% - 7%) * ($10,000/$40,000) = 17%.

A Firm Has a Market Value of Assets of $50