A company's CFO wants to maintain a target debt-to-equity ratio of 1/4. If the WACC is 18.6%, and the pretax cost of debt is 9.4%, what is the cost of common equity assuming a tax rate of 34%?

The calculated value of the company's cost of equity capital is option D. 22.73%.

Explanation:

The weighted average cost of capital (i.e. 18.6%) is given by:

= (Proportion of debt * pretax cost of debt * (1 - tax rate)) + (proportion of equity * cost of equity)

= (0.25 * 9.4% * (1 - 34%)) + (0.75 * cost of equity)

= 1.551% + (0.75 * cost of equity)

On rearranging the above equation we get, cost of equity:

=

(

18.6

%

−

1.551

%

)

0.75

=

17.049

%

0.75

= 22.73%

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