Question

Aspen's Distributors has a levered cost of equity of 13.84 percent and an unlevered cost of capital of 12.5 percent. The company has $5,000 in debt that is selling at par. The levered value of the firm is $14,600 and the tax rate is 25 percent. What is the pretax cost of debt?

A) 7.92 percent

B) 9.07 percent

C) 8.16 percent

D) 8.84 percent

Answer 1

Given about Aspen's distributors,

levered cost of equity Re(levered) = 13.84%

unlevered cost of capital Rc(unlevered) = 12.50%

Debt Vd= 5000

Levered Value of firm VL= $14600

So, Value of equity = VL - Vd = 14600 - 5000 = $9600

tax rate T = 25%

let before tax cost of debt be Rd

We know that,

Re(levered) = Rc(unlevered) + (Rc(unlevered) - Rd)*(Vd/Ve)*(1-T)

=> 13.84 = 12.5 + (12.5 - Rd)*(5000/9600)*(1-0.25)

=> 12.5 - Rd = 3.43

=> Rd = 9.07%

So, pre tax cost of debt = 9.07%

Option B is correct.