Eccles Inc., a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%.
-Refer to the data for Eccles Inc.What is the firm's cost of equity according to MM with corporate taxes?
A) 21.0%
B) 23.3%
C) 25.9%
D) 28.8%
E) 32.0%

Question

Quizplus · Accepted Answer

$ \mathrm{T}_{\mathrm{c}}: 30 \% $  $ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $EBIT: $ \$ 100,000 $
$ \mathrm{r}_{\mathrm{s}}U:16 \% $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $$ \quad $Debt: $ \$ 500,000 $ 
 $\begin{array}{c}
V_{U}=\mathrm{EBIT}(1-\mathrm{T}) 1_{s \mathrm{U}}= \
\mathrm{V}_{\mathrm{U}}=\$ 100,000(0.7) / 0.16=\$ 437,500 \
\mathrm{~V}_{\mathrm{L}}=\mathrm{V}_{\mathrm{U}}+\mathrm{TD}= \
V_{\mathrm{L}}=\$ 437,500+0.3(\$ 500,000)=\$ 587,500 \
\mathrm{~S}=\mathrm{V}_{\mathrm{E}}=\mathrm{V}_{\mathrm{L}}-\mathrm{D}= \
\mathrm{S}=\$ 587,500-\$ 500,000=\$ 87,500 \
\mathrm{r}_{\mathrm{L}}=\mathrm{I}_{\mathrm{SU}}+\left(\mathrm{I}_{\mathrm{S}}-\mathrm{r}_{\mathrm{d}}\right)(1-\mathrm{T})(\mathrm{D} / \mathrm{S})= \
\mathrm{I}_{\mathrm{LL}}=16 \%+(16 \%- \
12 \%)(0.7)(\$ 500,000 / \$ 87,500)=\mathbf{3 2 . 0 \%}
\end{array}$