Using the original Modigliani and Miller assumptions if a firm's cost of capital is 12% when it is all equity financed and its cost of debt is 8%, the cost of equity will be [blank] % when the firm is financed with equal amount of debt and equity.
A)12%
B)24%
C)16%
D)cannot be determined with the information given.

Question

Quizplus · Accepted Answer

According to Modigliani and Miller, the cost of equity in a leveraged firm is given by the formula: 
Cost of Equity = Cost of Unlevered Equity + (Cost of Debt − Tax Rate) x (Debt/Equity) 
Assuming that the tax rate is 0 and the firm's cost of un-levered equity is 12%, we can calculate the cost of equity as follows:

Cost of Equity = 12% + (8% - 0) x (1/1) 
Cost of Equity = 12% + 8% 
Cost of Equity = 16%

Using the Original Modigliani and Miller Assumptions If a Firm's