Question

Ace Pharmacy Inc. is a business dealing in pain reduction medication. It has a required return on its assets of 15%. It can borrow in the debt market at 8%. If there are no taxes and M&M's proposition il holds, what is the cost of equity if there is 50% equity financing and 50% debt financing? O A 22% O B. 26% O c. 18% OD. None of these

Answer 1

Solution:
	Answer is A. 22%
Working Notes:
	To get Ace pharmacy ’s cost of equity we will use M&M Proposition II formula.
	Re = Ra + (Ra - Rd) × (D/E) (1 – tC)
	Re= Cost of equity = ??
	Ra = Return on assets = 15%
	Rd = Cost of debt = 8%
	D/E = Debt Equity ratio =50%/50% = 1
	TC = Tax rate = 0%
	Re = Ra + (Ra - Rd) × (D/E) (1 – tC)
	= 15% + (15% - 8%)(1) (1-0)
	= 15% + 7%
	=22%
	Cost of equity is 22%
Please feel free to ask if anything about above solution in comment section of the question.