Spectronix Inc operates in a world of perfect capital markets, has no

Spectronix Inc operates in a world of perfect capital markets, has no debt, and has a required rate of return on equity of 10%.

An executive manager has suggested that borrowing money to buy back outstanding stock is a good idea because it would replace equity financing with less expensive debt financing, thus increasing the value of the firm. Assume the firm issues new debt with a required return of of 5% to repurchase 30% of the outstanding stock. What is the cost of equity at the conclusion of this transaction?
A) 21.67%
B) 12.14%
C) 16.43%
D) 45.00%

ANSWER

B
Explanation: B) Ke = Ku + (Ku – Kd)(D/E) = 10% + (10% – 5%)(.30/.70 ) = 12.14%.