Question

Gilbert & Sons is a levered firm. It has 300,000 shares of stock outstanding with a market price of $32 per share. The company also has $6.6 million of debt outstanding that sells at par. The pre-tax cost of debt is 9 percent and the unlevered cost of capital is 12 percent. What is the cost of equity if the tax rate is 35 percent? A) 12.00 percent B) 12.79 percent C) 13.34 percent D) 14.84 percent

why choose C here

Answer 1

Value of Equity = Number of shares outstanding * Market price per share
Value of Equity = 300,000 * $32
Value of Equity = $9,600,000

Value of Debt = $6,600,000

Debt-equity Ratio, D/E = Value of Debt / Value of Equity
Debt-equity Ratio, D/E = $6,600,000 / $9,600,000
Debt-equity Ratio, D/E = 0.6875

Unlevered Cost of Equity, rU = 12%
Cost of Debt, rD = 9%

Levered Cost of Equity, rE = rU + (1-tax)*(D/E)*(rU - rD)
Levered Cost of Equity, rE = 12% + (1 - 0.35)*(0.6875)*(12% - 9%)
Levered Cost of Equity, rE = 13.34%

So, cost of equity is 13.34%