Question

Winter's toyland has a debt-equity ratio of .65. the pretax cost of debt is 8.7 percent and the required return on assets is 16.1 percent. what is the cost of equity if you ignore taxes?

O 20.46 percent
O 19.31 percent
O 20.29 percent
O 20.91 percent
O 19.74 percent

Answer 1

The cost of equity for Winter's Toyland is calculated by using the formula Re = Ra + (Ra - Rd) * (D/E). By substituting the given values, the cost of equity is found to be 20.91 percent.

Step-by-step explanation:

The student's question revolves around finding the cost of equity for Winter's Toyland, given a debt-equity ratio of 0.65, a pretax cost of debt of 8.7 percent, and a required return on assets of 16.1 percent while ignoring taxes. We can use the following formula derived from the Modigliani-Miller Proposition II without taxes:

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

Where:

• Re is the cost of equity
• Ra is the required return on assets
• Rd is the pretax cost of debt
• D/E is the debt-equity ratio

Since we have a debt-equity ratio (D/E) of 0.65, a pretax cost of debt (Rd) of 8.7%, and a required return on assets (Ra) of 16.1%, we can substitute these values into the formula:

Re = 16.1% + (16.1% - 8.7%) * 0.65

By calculating, we get:

Re = 16.1% + (7.4% * 0.65)

Re = 16.1% + 4.81%

Re = 20.91%

Therefore, the cost of equity for Winter's Toyland, ignoring taxes, is 20.91 percent which is the mentioned correct option in final answer.