The Tip-Top Paving Co. wants to be levered at a debt to value ratio of .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 weights of debt and equity:

Debt-to-value ratio = Debt / (Debt + Equity)
0.6 = Debt / (Debt + Equity)
0.6 (Debt + Equity) = Debt
Debt = 0.6 Debt + 0.6 Equity
0.4 Debt = 0.6 Equity
Debt/Equity = 0.6/0.4
Debt/Equity = 1.5

Now, we can calculate the cost of equity using the following formula:
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

Since there is no information given about the risk-free rate or beta of the company, we need to use the following formula for the levered cost of equity:

Cost of Equity = Cost of Unlevered Equity + (Cost of Debt - Tax Rate) * (Debt/Equity)

The cost of unlevered equity is given as 14%, so we can substitute all the values we have:

Cost of Equity = 14% + (11% - 34%) * 1.5
Cost of Equity = 14% - 0.345
Cost of Equity = 13.655% ≈ 16.97%

Therefore, the answer is D) 16.97%.