Suppose that Rearden Metal currently has no debt and has an equity cost of capital of 12%. Rearden is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt - to-equity ratio of 50%, then Rearden's levered cost of equity would be closest to:A) 10.0%B) 12.0%C) 15.0%D) 16.0%

Question

Bentley Clay

Business

23 August, 10:55

Suppose that Rearden Metal currently has no debt and has an equity cost of capital of 12%. Rearden is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt - to-equity ratio of 50%, then Rearden's levered cost of equity would be closest to:A) 10.0%B) 12.0%C) 15.0%D) 16.0%

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Answers (1)

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Darius Keith · Answer 1

Option (C) is correct.

Explanation:

We have to use MM proposition that cost of equity will change itself in such a manner so that it can take care of its debt.

Cost of equity:

= WACC of all equity firm + (WACC of all equity - Cost of debt) * (Debt - to-equity ratio)

At the beginning, when there was no debt,

WACC = cost of equity = 12 %

Levered cost of equity:

= 12% + (12% - 6%) * 0.5

= 15%

Therefore, Rearden's levered cost of equity would be closest to 15%.