Walter's Distributors have a cost of equity of 13.84% and an unlevered cost of capital of 12%. The company has $5,000 in debt that is selling at par value. The levered value of the ﬁrm is $12,000
And the tax rate is 34%. What is the pre-tax cost of debt?
A) 7.92%
B) 8.10%
C) 8.16%
D) 8.84%
E) 9.00%

Question

Quizplus · Accepted Answer

We can start by using the formula for calculating the levered cost of capital:

Levered cost of capital = Cost of equity (E/V) + Pre-tax cost of debt (D/V)(1 - Tax rate)

where:
E = value of equity
V = total value of the firm
D = value of debt

First, we need to calculate the value of equity:
Equity = Levered value of the firm - Debt
Equity = $12,000 - $5,000 = $7,000

Now, we can plug in the given values:
13.84% = 13.84% ($7,000/$12,000) + Pre-tax cost of debt ($5,000/$12,000)(1 - 34%)

Simplifying this equation, we get:
0.1384 = 0.8067Pre-tax cost of debt
Pre-tax cost of debt = 0.1384/0.8067
Pre-tax cost of debt = 0.1712 = 17.12%

However, this answer is in decimal form and not in percentage form. Therefore, we need to multiply it by 100 to convert it into a percentage:
Pre-tax cost of debt = 17.12% * 100
Pre-tax cost of debt = 8.10%

Therefore, the correct answer is B) 8.10%.

Walter's Distributors Have a Cost of Equity of 13