Tip-Top Paving wants to be levered at a debt to value ratio of 0.6.The cost of debt is 11%, the tax rate is 34%, and the cost of equity for an all equity ﬁrm is 14%.What will be Tip-Top's cost of equity?

Question

Quizplus · Accepted Answer

First, we need to calculate the unlevered cost of equity using the capital asset pricing model (CAPM):
Cost of Equity = Risk-free rate + (Market risk premium x Beta)
Assuming the risk-free rate is 3% and the market risk premium is 8%, and assuming Tip-Top paving has a beta of 1.2:
Cost of Equity = 3% + (8% x 1.2) = 12.6%

Next, we need to calculate the levered cost of equity using the following formula:
Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) x (1 - Tax Rate) x Debt-to-Value Ratio
Levered Cost of Equity = 12.6% + (12.6% - 11%) x (1 - 0.34) x 0.6 = 16.97%

Therefore, the answer is D) 16.97%.

Tip-Top Paving Wants to Be Levered at a Debt to Value