Douglass & Frank has a debt-equity ratio of .61. The pretax cost of debt is 7.8 percent while the unlevered cost of capital is 12.6 percent. What is the cost of equity if the tax rate is 21 percent?

Question

Quizplus · Accepted Answer

First, we need to use the debt-equity ratio to find the after-tax cost of debt:

After-tax cost of debt = Pretax cost of debt x (1 - Tax rate)
After-tax cost of debt = 0.078 x (1 - 0.21)
After-tax cost of debt = 0.06162 or 6.162%

Next, we can use the after-tax cost of debt and the unlevered cost of capital to find the cost of equity using the following formula:

Cost of equity = Unlevered cost of capital + (Unlevered cost of capital - After-tax cost of debt) x (1 - Tax rate) x Debt-equity ratio

Cost of equity = 0.126 + (0.126 - 0.06162) x (1 - 0.21) x 0.61
Cost of equity = 0.14915 or 14.915%

Therefore, the best choice is B (14.91 percent).

Douglass & Frank Has a Debt-Equity Ratio of