Final answer:
To calculate the pretax cost of debt for Home Depot with a debt-equity ratio of 0.86, WACC of 7.11%, and levered cost of equity of 10.54%, we use the weights of debt and equity in the WACC formula and solve for Rd. The result is a pretax cost of debt of approximately 3.95%, which corresponds to option D.
Step-by-step explanation:
The student's question pertains to the calculation of the pretax cost of debt using MM Proposition I with no taxes. To find the pretax cost of debt, we must understand the relationship between the debt-equity ratio, WACC (Weighted Average Cost of Capital), and the levered cost of equity. MM Proposition I without taxes asserts that the value of the firm is not affected by its capital structure.
Using the formula for WACC, which is WACC = E/V * Re + D/V * Rd * (1 - Tc), where E/V is the proportion of equity financing, D/V is the proportion of debt financing, Re is the cost of equity, Rd is the cost of debt, and Tc is the tax rate (which is zero in this case). We can rearrange the formula to solve for Rd, knowing that debt-equity ratio D/E = 0.86, and therefore D/V = 0.86/(1+D/E) = 0.86/1.86 = 0.4624, and E/V = 1 - D/V = 0.5376. Applying all known values to the WACC formula results in 7.11% = 0.5376 * 10.54% + 0.4624 * Rd. Solving for Rd gives us the pretax cost of debt.
The correct calculation of Rd results in a pretax cost of debt of approximately 3.95%, which is option D.