Jefferson Electrical Supply has a cost of equity of 12% and an unlevered cost of capital of 10.5%. The company has $12,000 in debt that is selling at par value. The levered value of the firm is $28,000 and the tax rate is 34%. What is the pre-tax cost of debt?

Question

Quizplus · Accepted Answer

The pre-tax cost of debt can be calculated using the Modigliani-Miller Proposition II with taxes. The formula is: $r_d = r_0 + (r_0 - r_e) \times \frac{D}{E} \times (1 - T_c)$, where $r_d$ is the pre-tax cost of debt, $r_0$ is the unlevered cost of capital, $r_e$ is the cost of equity, $D$ is the value of debt, $E$ is the value of equity, and $T_c$ is the tax rate. Rearranging the formula to solve for $r_d$ and substituting the given values: $E = V - D = 28000 - 12000 = 16000$, so $r_d = 10.5\% + (10.5\% - 12\%) \times \frac{12000}{16000} \times (1 - 0.34)$. Solving this gives $r_d = 7.47\%$.

Jefferson Electrical Supply Has a Cost of Equity of 12