The Pizza Palace has a cost of equity of 14.4% and an unlevered cost of capital of 10%. The company has $18,000 in debt that is selling at par value. The levered value of the firm is $32,000 and the tax rate is 35%. What is the pre-tax cost of debt?
A) 4.73%
B) 6.18%
C) 6.59%
D) 7.38%
E) 9.92%

Question

Quizplus · Accepted Answer

The pre-tax cost of debt is calculated as follows:Pre-tax cost of debt = Unlevered cost of capital + (Levered cost of capital - Unlevered cost of capital) * (Debt / Value of the firm) * (1 - Tax rate)= 10% + (14.4% - 10%) * (18,000 / 32,000) * (1 - 35%)= 10% + 0.144 * 0.5625 * 0.65= 10% + 0.0473= 10.0473%Therefore, the pre-tax cost of debt is 10.0473%, which is closest to choice A) 4.73%.

The Pizza Palace Has a Cost of Equity of 14