Question

Hatter, Inc., has equity with a market value of $23.1 million and debt with a market value of $9.24 million. The cost of debt is 10 percent per year. Treasury bills that mature in one year yield 6 percent per year, and the expected return on the market portfolio over the next year is 11 percent. The beta of the company’s equity is 1.16. The firm pays no taxes.

a. What is the company’s debt−equity ratio? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Debt–equity ratio            

b. What is the company's weighted average cost of capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Weighted average cost of capital             %

c. What is the cost of capital for an otherwise identical all-equity firm? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of capital             %

Answer 1

a. The company's debt-equity ratio = $ 9.24 million / $ 23.1 million = 0.40

b. Weighted Average Cost of Capital : 11.29 %

Cost of Equity = 0.06 + 1.16 ( 0.11 - 0.06) = 0.118

Cost of Debt = 0.10

Source of Capital	MV	Weights	Specific Cost of Capital	Weighted Cost of Capital
Equity	23.1	0.71429	0.118	0.08429
Debt	9.24	0.28571	0.10	0.02857
	32.34	1.00000		0.11286

c. Cost of capital for an otherwise identical all equity firm : 11.29%

As per Modigliani-Miller proposition, in the absence of taxes, the cost of capital of an all equity company is the same as the weighted average cost of a levered company.