Question

Werner Company has debt with both a face and a market value of $7,200,000. This debt has a coupon rate of 5.8 percent and pays interest annually. The expected earnings before interest and taxes are $2,512,000, the tax rate is 25 percent, and the unlevered cost of capital is 10.4 percent. What is the firm's cost of equity? 13.04% 12.67% 11.93% 12.35% 11.76%

Answer 1

The debt has both face and market value of $7,200,000. The I/Y(cost of debt )  will be 5.8%,

The unlevered cost if equity is 10.4%,

The value of firm is = EBIT(1 - TAX RATE)/ COST OF EQUITY

= $2,512,000* 0.75/ .104

=$18,115,384.6

Value of firm = $18,115,384.6

Debt = $7,200,000

EQUITY = $10,915,384.6

D/E = $7,200,000/ $10,915,384.6

D/E = 0.659

Re = Ro + D/E ( Ro - Rd)(1 - tax rate), where Ro = unlevered cost of equity , Rd = cost of debt

=10.4+ 0.659 ( 10.4 - 5.8) (1 - 0.25)

= 12.67%

So, the correct option is option 2.