Explanation:

The correct answer is B (11.3%). According to the Modigliani-Miller propositions, the cost of equity for a company with debt is calculated as:

$r_e = r_0 + (r_0 - r_d)(1 - t)\left(\frac{D}{E}\right)$

Where:

• $r_e$ = Cost of equity
• $r_0$ = Unlevered cost of capital (9.0%)
• $r_d$ = Cost of debt (4.0%)
• $t$ = Tax rate (25%)
• $D$ = Market value of debt (£15,000)
• $E$ = Market value of equity (£25,000, derived from £40,000 - £15,000)

Substituting the values:

$r_e = 0.09 + (0.09 - 0.04)(1 - 0.25)\left(\frac{15,000}{25,000}\right) = 0.1125 \text{ or } 11.3\%$

Why not A or C?

• A (10.4%): Incorrect because it uses the total company value instead of equity value in the calculation.
• C (12.0%): Incorrect because it ignores the tax shield benefit of debt, reflecting the cost of equity in the absence of corporate taxes.