Question

A firm has an equity multiplier of 1.57, an unlevered cost of equity of 14 percent, a levered cost of equity of 15.6 percent, and a tax rate of 21 percent. What is the cost of debt?

1)11.25%

2)10.50%

3)10.45%

4)11%

5)10.33%

Answer 1

The cost of debt is computed as shown below:

Levered cost of equity = [ Unlevered cost of equity + (Unlevered cost of equity - cost of debt) x (Debt / Equity) x (1 - tax rate) ]

Debt / Equity is computed as follows:

= Equity multiplier - 1

= 1.57 - 1

= 0.57

So, the cost of debt will be as follows:

0.156 = [ 0.14 + (0.14 - cost of debt) x 0.57 x (1 - 0.21) ]

0.156 = 0.14 + (0.14 - cost of debt) x 0.4503

0.156 - 0.14 = (0.14 - cost of debt) x 0.4503

0.016 = 0.063042 - 0.4503 cost of debt

cost of debt = (0.063042 - 0.016) / 0.4503

cost of debt = 10.45% Approximately

So, the correct answer is option 3.

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