Question

APM Inc. is in the property management business and has a required return on its assets of​ 14%. It can borrow in the debt market at​ 7%. If there are no taxes and​ M&M's proposition II​ holds, what is the cost of equity if there is​ 30% equity financing and​ 70% debt​ financing?

Answer 1

Answer:

Cost of equity is 30.33%

Explanation:

A required return on assets of 14% means that a company requires a minimum acceptable rate of return of 14% at any investment which must yield the said return for its investors or for the resources/assets invested therein. We may use this return as the Company's Weighted Average Cost of Capital (WACC).

WACC formula:

WACC = ((Weight of debt financing) * (after tax cost of debt)) + ((Weight of equity financing) * (cost of equity))

Substituting the values, we get "X" as the weighted cost of equity (assuming no taxes as stated in the problem):

14% = (70%*7%) + X

14% = 4.900% + X

X = 9.100%

To get the cost of equity, we substitute the values for the following formula of the weighted cost of equity to get "X" as the cost of equity:

Weighted cost of equity = Weight of equity financing * cost of equity

9.100% = 30% * X

X = 30.33%

Cost of equity is 30.33%