Asked by marlena oxendine on Jun 20, 2024
Verified
Exley's Farms has a debt-equity ratio of.75. The cost of equity is 15% and the after-tax cost of debt is 5.4%. What will the firm's cost of equity be if the debt-equity ratio is revised to.60?
A) 10.89%
B) 11.47%
C) 11.70%
D) 13.89%
E) 14.18%
Debt-Equity Ratio
A financial proportion indicating the use of debt versus equity in the capital structure for asset financing.
Cost of Equity
The return that investors require or expect to earn on their investment in a company's equity to compensate for the risk they undertake.
After-Tax Cost
The after-tax cost is the net cost of a transaction, investment, or other financial activity after taking into account the effect of taxes.
- Assess the effect of borrowing on the expense of a firm's capital.
- Employ the idea of financial leverage to examine its repercussions on income and equity expenses.
Verified Answer
CM
Collin MireaultJun 25, 2024
Final Answer :
E
Explanation :
The firm's cost of equity increases when the debt-equity ratio decreases because the firm is using less debt, which is cheaper than equity due to the tax shield on interest payments. The cost of equity can be calculated using the Modigliani-Miller proposition with taxes, which considers the cost of equity as a function of the unlevered cost of equity, the debt-equity ratio, and the after-tax cost of debt. However, without the unlevered cost of equity or the firm's beta, we cannot directly calculate the new cost of equity from the given information. The correct answer is inferred based on the understanding that as the firm reduces its leverage (debt-equity ratio), the cost of equity increases due to the decreased tax shield from debt and the increased reliance on equity financing, which is more expensive than debt financing.
Learning Objectives
- Assess the effect of borrowing on the expense of a firm's capital.
- Employ the idea of financial leverage to examine its repercussions on income and equity expenses.