Question

Black Inc. is a manufacturing company with a cost of debt of 6.5%. The company is financed equally by equity and debt and is subject to a tax rate of 20%. An analyst investigating the optimal capital structure for the firm has estimated that the cost of equity of the company if it had no debt would be 8%. According to Modigliani and Miller proposition II with taxes, the cost of equity of the company is closest to:

a) 6.6%.
b) 7.3%.
c) 9.2%.
d) 6.2%.

Answer 1

According to Modigliani and Miller proposition II with taxes, the cost of equity of a company is calculated by adding the cost of debt multiplied by (1 - tax rate) to the cost of equity if the company had no debt.

Step-by-step explanation:

According to Modigliani and Miller proposition II with taxes, the cost of equity of the company is calculated by adding the cost of debt multiplied by (1 - tax rate) to the cost of equity if the company had no debt. In this case, the cost of equity if the company had no debt is 8%. The cost of debt is 6.5% and the tax rate is 20%. Therefore, the cost of equity of the company is:

8% + (6.5% * (1 - 0.20)) = 8% + (6.5% * 0.80) = 8% + 5.2% = 13.2%

Therefore, the closest option to the cost of equity of the company according to Modigliani and Miller proposition II with taxes is 13.2%, which is not listed in the given answer choices.