Until now, Delaware East, Inc has been an all-equity firm; its most re

Until now, Delaware East, Inc has been an all-equity firm; its most recent market equity value was $80 mn., and its cost of equity (and cost of assets) is 15%. Now, the firm decides to increase its leverage by issuing $40 mn.

in debt, with the proceeds being used to pay a dividend to shareholders. The cost of the debt is rD=7%. What is the firm’s new cost of equity capital, according to Modigliani and Miller’s Proposition II?
a. 15.33%
b. 18.20%
c 20.33%
d. 23.00%
FORMULA: rE = rA + (D/E)[rA – rD].

ANSWER

D