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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

A company's equity is Rs 80 crore and its net debt is Rs 20 crore, both at market value. Its cost of debt is 8% pre-tax with no taxes. The ungeared cost of equity is 12%. Using MM Proposition II without tax, what is the cost of equity of the geared company?

The geared cost of equity is 13%. MM Proposition II gives Ke = 12% + (12% - 8%) x 20/80 = 13%. Checking, the weighted cost 0.8 x 13% + 0.2 x 8% equals 12%, the ungeared cost, as required without taxes.

  1. A12.0%
  2. B13.0%Correct
  3. C14.0%
  4. D15.0%
  5. 16.0%

Explanation

Ke = Ku + (Ku - Kd) x D/E = 12% + (12% - 8%) x 20/80 = 12% + 1% = 13%. Check: WACC = 0.8 x 13% + 0.2 x 8% = 10.4% + 1.6% = 12%, equal to Ku, as MM without tax requires.

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