Based on the MM propositions with corporate taxes, Garth’s cost of equity after the debt issuance is closest to:

Lindsay White, CFA, is an analyst with a firm in London, England. She is responsible for
covering five companies in the Consumer Staples industry. White believes the domestic and
global economies will grow slightly below average over the next two years, but she is also
concerned about the possibility of a mild recession taking hold. She has been asked to review
the companies that she covers and has collected information about them, presented in Exhibit
C. White has estimated that earnings before interest and taxes (EBIT) will remain constant for
all five companies for the foreseeable future. Currency is in terms of the British pound (d).
The marginal corporate tax rate is 30 percent for all five companies.
EXHIBIT C Selected Company Financial Data
Aquarius Bema Garth Holte Vega
EBIT (d) 600,000 600,000 400,000 400,000 400,000
Debt-to-equity ratio (market value) 0.60 0.00 0.00 0.71 0.62
Debt (market value) (d) 2,000,000 0 0 2,000,000 2,000,000
S&P debt rating Aþ n.a. n.a. A– A
Weighted average cost of capital – 10% 10% – –
Based on conversations with management of the five companies, as well as on her own
independent research and analysis, White notes the following:
Aquarius:

Has lower bonding costs than does Bema.

Has a higher percentage of tangible assets to total assets than does Bema.

Has a higher degree of operating leverage than does Bema.
Garth:

Invests significantly less in Research and Development than does Holte.

Has a more highly developed corporate governance system than does Holte.

Has more business risk than does Holte.
In addition, White has reached various conclusions regarding announcements by Bema,
Garth, and Vega:
Announcement: Bema has announced that it will issue debt and use the proceeds to
repurchase shares. As a result of this debt-financed share repurchase
program, Bema indicates that its debt/equity ratio will increase to 0.6
and its before-tax cost of debt will be 6 percent.
Conclusion: As result of the announced program, Bema’s total market value should
decrease relative to Aquarius’s.
Announcement: Garth has announced that it plans to abandon the prior policy of allequity financing by the issuance of d1 million in debt in order to buy
back an equivalent amount of equity. Garth’s before-tax cost of debt
is 6 percent.
Conclusion: This change in capital structure is reasonable, but Garth should take
care subsequently to maintain a lower D/E ratio than Holte.
Announcement: Vega has announced that it intends to raise capital next year, but is
unsure of the appropriate method of raising capital.
Conclusion: White has concluded that Vega should apply the pecking order theory
to determine the appropriate method of raising capital.
A. 10.00%.
B. 10.85%.
C. 11.33%.

Ans: C. 11.33%.