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Jonny T
Jonny T.'s expected earnings before interest and taxes are $5,000. Its debt has both a face and a market value of $15,000. This debt has a coupon rate of 10 percent and pays interest annually. The company's unlevered WACC is 12% (i.e. the firm's WACC would have been 12% if it was fully equity-financed). The tax rate is 30 percent. Assume the earnings will remain the same every year forever and all the net earnings will be paid out to shareholders. What is the firm's cost of equity?
A) 10.00%
B) 12.00%
C) 13.13%
D) 14.22%
E) 20.14%
Expert Solution
Computation of the firm's cost of equity:-
Value of unlevered firm = EBIT * (1 - tax rate) / Unlevered WACC
= $5,000* (1 - 30%) / 12%
= $29,166.67
Value of levered firm = Value of unlevered firm + (Tax rate * Value of Debt)
= $29,166.67 + (30% * $15,000)
= $29,166.67 + $4,500
= $33,666.67
Value of equity = Value of firm - Value of debt
= $33,666.67 - $15,000
= $18,666.67
Cost of equity = Unlevered cost of equity + ((Unlevered cost of equity - Cost of debt) * (Debt / Equity) * (1 - tax rate))
= 12% + ((12% - 10%) * ($15,000 / $18,666.67) * (1 - 30%))
= 12% + (2% * 0.80 * 70%)
= 12% + 1.13%
= 13.13%
Hence, the correct option is C) 13.13%
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