A firm has zero debt in its capital structure.Its overall cost of capital is 10%.The firm is considering a new capital structure with 60% debt.The interest rate on the debt would be 8%.Assuming there are no taxes or other imperfections, its cost of equity capital with the new capital structure would be _____.
A)9%
B)10%
C)13%
D)14%
E)None of the above.

Question

Quizplus · Accepted Answer

Using the formula for the overall cost of capital (WACC):

WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc)

Where: 
E = Market value of the firm's equity 
D = Market value of the firm's debt 
V = E + D
Re = Cost of equity 
Rd = Cost of debt 
Tc = Corporate tax rate

Since the company currently has no debt, V = E

WACC = E/V x Re

10% = Re

If the new capital structure has 60% debt, then D/V = 0.6 and E/V = 0.4

WACC = (0.4 x Re) + (0.6 x 8%)

10% = (0.4 x Re) + 4.8%

Re = 13%

Therefore, the cost of equity capital with the new capital structure would be 13%.

A Firm Has Zero Debt in Its Capital Structure