A firm has zero debt and an overall cost of capital of 13.8 percent. The firm is considering a new capital structure with 40 percent debt. The interest rate on the debt would be 7.2 percent and the corporate tax rate is 34 percent. What would be the cost of equity with the new capital structure

Answer: 16.70%

First we need to compute levered cost of equity

Ro = 15.40%

D/E ratio = 0.40 / (1-0.40) = 0.6667

Rd=7.2%

We have following formula for levered cost of equity using MM model proposition II:

Without taxes

Re = Ro + (Ro - Rd) x (1-t) x D/E

= 0.1380 + (0.1380-0.0720) x (1-0.0) x0.6667

= 0.1380 + 0.0440

= 18.20%

Therefore, new cost of equity would be 18.20%.

With taxes

Re = Ro + (Ro - Rd) x (1-t) x D/E

= 0.1380 + (0.1380-0.0720) x (1-0.34) x0.6667

= 0.1380 + 0.0290

= 16.70%

Therefore, new cost of equity would be 16.70%.