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Al's Pub has debt with both a book and a market value of $120,000. This debt...

Al's Pub has debt with both a book and a market value of $120,000. This debt has a coupon rate of 9% and pays interest annually. The expected earnings before interest and taxes are $42,600, the tax rate is 34%, and the unlevered cost of capital is 11%. What is the firm's cost of equity?

a. 11.90%

b. 12.15%

c. 12.11%

d. 12.18%

e. 12.07%

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Answer #1

Answer is 11.90%

Value of Unlevered Firm = EBIT * (1 - Tax Rate) / Unlevered Cost of Equity
Value of Unlevered Firm = $42,600 * (1 - 0.34) / 0.11
Value of Unlevered Firm = $255,600

Value of Levered Firm = Value of Unlevered Firm + Tax Rate * Value of Debt
Value of Levered Firm = $255,600 + 0.34 * $120,000
Value of Levered Firm = $296,400

Value of Equity = Value of Levered Firm - Value of Debt
Value of Equity = $296,400 - $120,000
Value of Equity = $176,400

Debt-Equity Ratio = Value of Debt / Value of Equity
Debt-Equity Ratio = $120,000 / $176,400
Debt-Equity Ratio = 0.68027

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Value of Debt) * (1 - Tax Rate) * Debt-Equity Ratio
Levered Cost of Equity = 0.1100 + (0.1100 - 0.0900) * (1 - 0.34) * 0.68027
Levered Cost of Equity = 0.1100 + 0.0090
Levered Cost of Equity = 0.1190 or 11.90%

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