Question

Suppose that Taggart Transcontinental currently has no debt and has an equity cost of capital of 10%. Taggart is considering borrowing funds at a cost of 6% and using these funds to repurchase existing shares of stock. Assume perfect capital markets. If Taggart borrows until they achieved a debt -to-value ratio of 20%, then Taggart's levered cost of equity would be closest to:A) 8.0%B) 9.2%C) 10.0%D) 11.0%

Answer 1

Answer:

Option (D) is correct.

Explanation:

We have to use MM proposition that cost of equity will change itself in such a manner so that it can take care of its debt.

Cost of equity:

= WACC of all equity firm + (WACC of all equity - Cost of debt ) × (Debt -to-equity ratio)

At the beginning, when there was no debt,

WACC = cost of equity = 10%

Levered cost of equity:

= 10% + ( 10% - 6%) × 0.2

= 10.8%

Therefore, Taggart's levered cost of equity would be closest to 11%.