Uptown Appliances has an unlevered cost of capital of 14%, a tax rate of 35%, and expected earnings before interest and taxes of $8,200. The company has $15,000 in bonds outstanding that have a 7.5% coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?
A) 16.03%
B) 16.11%
C) 16.24%
D) 16.48%
E) 16.97%

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes: Cost of Equity = Unlevered Cost of Capital + (Unlevered Cost of Capital - After-tax Cost of Debt) * (Debt/Equity). Here, the after-tax cost of debt is 7.5% * (1 - 0.35) = 4.875%. The equity value can be found by subtracting the debt from the firm's value, which is the present value of the unlevered firm's earnings. Solving gives a cost of equity of approximately 16.24%.

Uptown Appliances Has an Unlevered Cost of Capital of 14