Question

Alpha Co. has a debt-equity ratio of 0.6, a pretax cost of debt of 7.5 percent, and an unlevered cost of equity of 12 percent. What is Alpha's cost of equity if you ignore taxes?

Multiple choice question.
A.16.5%
B.9.3%
C.14.7%
D.12%
Explain why

Answer 1

The levered cost of equity for Alpha Co. is calculated using the Modigliani-Miller proposition II without taxes, resulting in 14.7%, which is option C from the multiple-choice options.

Step-by-step explanation:

The question asks us to calculate Alpha Company's levered cost of equity, given its debt-equity ratio, pretax cost of debt, and unlevered cost of equity while ignoring taxes. To find this, we can use the Modigliani-Miller proposition II without taxes (since we are ignoring taxes in this scenario). The formula for the cost of equity is:

Re = Ru + (Ru - Rd) * (D/E)

Where Re is the levered cost of equity, Ru is the unlevered cost of equity, Rd is the pretax cost of debt, and D/E is the debt-equity ratio. Plugging in the values we have:

Re = 12% + (12% - 7.5%) * 0.6

Re = 12% + 4.5% * 0.6

Re = 12% + 2.7%

Re = 14.7%

Thus, the levered cost of equity for Alpha Co. is 14.7%, which corresponds to option C.