Question

Debbie's Cookies has a return on assets of 9.3 percent and a cost of equity of 12.4 percent. What is the pretax cost of debt if the debt-equity ratio is 0.88? Ignore taxes.

• 5.25%

• 6.42%

• 6.68%

• 5.78%

• 6.10%

Answer 1

Return on assets = 9.3%

Cost of Equity = 12.4%

Debt-Equity ratio = 0.88

To determine pretax cost of debt:

Cost of Equity = Return on assets + (Return on assets - Cost of Debt) x Debt-Equity ratio

12.4% = 9.3% + (9.3% - Cost of Debt) x 0.88

0.124 = 0.093 + (0.093 - Cost of Debt) x 0.88

0.124 = (0.093 + 0.08184) - 0.88 Cost of Debt

0.124 = 0.17484 - 0.88 Cost of Debt

0.88 Cost of Debt = 0.17484 - 0.124

0.88 Cost of Debt = 0.05084

Cost of Debt = 0.05084 / 0.88

Cost of Debt = 0.057773 or 5.78%

Therefore pretax cost of debt will be 5.78%