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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

Rohan Textiles has an unlevered cost of equity of 15%, and the corporate tax rate is 30%. It holds permanent debt at a market D/E of 0.4 with cost of debt of 9%. Using MM with corporate tax, what is the cost of equity of the levered firm?

The levered cost of equity is about 16.7%. MM with corporate tax gives Ke = K0 + (K0 - Kd)(1 - T)D/E, which is 15% + 6% x 0.7 x 0.4 = 16.68%. The tax shield dampens the increase in equity risk compared with the no-tax case.

  1. A15.0%
  2. B17.5%
  3. C16.7%Correct
  4. D18.0%
  5. 19.4%

Explanation

Ke = K0 + (K0 - Kd)(1 - T) D/E = 15% + 6% x 0.7 x 0.4 = 15% + 1.68% = 16.68%, about 16.7%. Ignoring tax gives 15% + 6% x 0.4 = 17.4%, which is not offered, and 18.0% results from other misuse. The tax-adjusted answer is the only one that matches.

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