Salmon Inc. has debt with both a face and a market value of $3,000. This debt has a coupon rate of 7% and pays interest annually. The expected earnings before interest and taxes is $1,200,the tax rate is 34%,and the unlevered cost of capital is 12%. What is the firm's cost of equity?
A) 13.25%
B) 13.89%
C) 13.92%
D) 14.14%
E) 14.25%

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes: $ r_e = r_0 + (r_0 - r_d) \times \frac{D}{E} \times (1 - T_c) $. Here, $ r_0 = 12\% $, $ r_d = 7\% $, $ D = 3000 $, $ E = 1200 \times (1 - 0.34) = 792 $, and $ T_c = 34\% $. Solving gives $ r_e \approx 14.14\% $.