Bellamee, Inc. has a required rate of return on its assets of 12% and a cost of debt of 6.25%. Its current debt-to-equity ratio is 1/5. What is its required return on equity if its debt-to-equity ratio changes to 2/5 and this increases the required rate of return on its debt to 7%?
A) 14%
B) 14.25%
C) 14.50%
D) 15%

Question

Quizplus · Accepted Answer

The correct answer is A.The required return on equity can be calculated using the weighted average cost of capital (WACC) formula:WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)where:E/V is the equity-to-value ratioRe is the required return on equityD/V is the debt-to-value ratioRd is the required return on debtTc is the corporate tax rateIn this case, the required rate of return on assets is 12%, the cost of debt is 6.25%, the current debt-to-equity ratio is 1/5, and the corporate tax rate is not given.If the debt-to-equity ratio changes to 2/5 and the required rate of return on debt increases to 7%, the new WACC can be calculated as follows:WACC = (1/5) * Re + (2/5) * 0.07 * (1 - Tc)Since the corporate tax rate is not given, we cannot calculate the exact required return on equity. However, we can see that the new WACC will be higher than the old WACC, which means that the required return on equity will also be higher.Therefore, the correct answer is A.