Question

Aspen's Distributors has a levered cost of equity of 13.84 percent and an unlevered cost of capital of 12.5 percent. The company has $5,000 in debt that is selling at par. The levered value of the firm is $14,600 and the tax rate is 34 percent. What is the pretax cost of debt?

Answer 1

Answer:

8.60%

Explanation:

We use the MM proposition II with taxes

$r_e = r_a + \frac{D}{E} (r_a-r_d)(1-t)$

ra 0.125

D 5000

E 9600 (14,600 assets = 5,000 liab + equity)

rd ??

taxes 0.34

re 0.1384

We set p the formula and solve:

$0.1384 = 0.125 + \frac{5,000}{9,600} (.125-r_d)(1-.34)$

$0.1384 = 0.125 + \frac{5,000}{9,600} (.125-r_d)(1-.34)$

$0.1384 - 0.125 = 0.34375 (.125-r_d)$

$0.0134 = 0.34375\times 0.125 - 0.34375\times r_d$

$r_d = (0.34375\times 0.125 - 0.0134)\div 0.34375$

rd = 0.860181818 = 8.60%