Question

A company has an unlevered cost of capital of 12 percent, a tax rate of 34...

A company has an unlevered cost of capital of 12 percent, a tax rate of 34 percent, and expected earnings before interest and taxes of $1,300. The company has $2,200 in bonds outstanding that have an 8 percent coupon and pay interest annually. The bonds are selling at par value.

What is the cost of equity?

How do you calculate this?

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Answer #1

Answer:

Value of Unlevered = [EBIT * (1 – tax rate)] / Unlevered Cost of Capital
Value of unlevered = [$1,300 * (1 – 0.34)] / 0.12
Value of Unlevered = $858 / 0.12
Value of Unlevered = $7,150

Value of Firm = Value of Unlevered + (tax rate *bond value)
Value of Firm = $7,150 + (0.34* $2,200)
Value of Firm = $7,150 + $748
Value of Firm = $7,898

Value of Equity = Value of Firm – Bond Value
Value of Equity = $7,898 - $2,200
Value of Equity = $5,698

Cost of Equity = Unlevered Cost of Capital + [(Unlevered Cost of Capital – Bond Rate) * (Bond Value /Value of Equity) * (1-tax rate)]
Cost of Equity = 0.12 + [(0.12-0.08)* ($2,200 / $5,698) * (1 – 0.34)]
Cost of Equity = 0.12 + [0.04 * 0.3861 * 0.66]
Cost of Equity = 0.12 + 0.0102
Cost of Equity = 0.1302 or 13.02%

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