The Tip-Top Paving Co. wants to be levered at a debt to value ratio of .6. The cost of debt is 11% 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 calculate the debt to equity ratio, which is 0.6/1-0.6 = 1.5. Then, use the formula for levered cost of equity:

Cost of equity = Cost of unlevered equity + (Cost of debt - Tax rate) x Debt/Equity

Since Tip-Top is an all equity firm, the cost of unlevered equity is simply 14%. Furthermore, no information is given about the tax rate, so assume it is 0. Therefore, the cost of equity becomes:

Cost of equity = 14% + (11% - 0) x 1.5 
Cost of equity = 16.97%

Therefore, the answer is D.