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Johnson Tire Distributors has an unlevered cost of capital of 13 percent, a tax rate of...

Johnson Tire Distributors has an unlevered cost of capital of 13 percent, a tax rate of 35 percent, and expected earnings before interest and taxes of $1,900. The company has $3,600 in bonds outstanding that have a 6 percent coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

13.76 percent

15.29 percent

10.70 percent

9.17 percent

12.23 percent

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Answer #1

Value of unlevered firm = Expected EBIT x (1 - tax rate) / Unlevered cost of capital = $1900 x (1 - 0.35) / 13% = $9500

Value of levered firm = Value of unlevered firm + Value of bonds or debt x tax rate = $9500 + $3600 x 35% = $10760

Value of Equity = Value of levered firm - Value of bonds or debt = $10760 - $3600 = $7160

As per MM Proposition II, cost of equity of a levered firm can be computed as -

where, ROE = return on equity or cost of equity, Kd = pre tax cost of debt, T = tax rate, D/E = Debt to equity ratio

% or 15.29%

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