Question

A company has a cost of equity of 13.06% and an unlevered cost of capital of...

A company has a cost of equity of 13.06% and an unlevered cost of capital of 9.22%. The company has $16,720 in debt that is selling at par value. The levered value of the firm is $29,724, and the tax rate is 25%. What is the pre-tax cost of debt?

Question 3 options:

4.98%

5.11%

5.24%

5.37%

5.50%
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Homework Answers

Answer #1

Answer is 5.24%

Value of Debt = $16,720

Value of Firm = Value of Debt + Value of Equity
$29,724 = $16,720 + Value of Equity
Value of Equity = $13,004

Debt-Equity Ratio = Value of Debt / Value of Equity
Debt-Equity Ratio = $16,720 / $13,004
Debt-Equity Ratio = 1.28576

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (1 - Tax Rate) * Debt-Equity Ratio
0.1306 = 0.0922 + (0.0922 - Cost of Debt) * (1 - 0.25) * 1.28576
0.0384 = (0.0922 - Cost of Debt) * 0.75 * 1.28576
0.0384 = (0.0922 - Cost of Debt) * 0.96432
0.0398 = 0.0922 - Cost of Debt
Cost of Debt = 0.0524 or 5.24%

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