Hey Guys!, Inc. has debt with both a book and a market value of $3,000. This debt has a coupon rate of 7% and pays interest annually. The expected earnings before interest and taxes are $1,200, the tax rate is 34%, and the unlevered cost of capital is 12%. What is the firm's cost of equity?
A) 13.25%
B) 13.89%
C) 13.92%
D) 14.14%
E) 14.25%

Question

Quizplus · Accepted Answer

The firm's cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes. The formula is: Cost of Equity = Unlevered Cost of Capital + (Unlevered Cost of Capital - After-Tax Cost of Debt) * (Debt/Equity). First, calculate the after-tax cost of debt: 7% * (1 - 0.34) = 4.62%. Then, calculate the equity value: EBIT - Interest = $1,200 - $210 = $990; Equity = $990 / 0.12 = $8,250. Finally, apply the formula: 12% + (12% - 4.62%) * ($3,000/$8,250) = 14.14%.