Question

Lamey Co. has an unlevered cost of capital of 10.9 percent, a tax rate of 35 percent, and expected earnings before interest and taxes of $21,800. The company has $25,000 in bonds outstanding that sell at par and have a coupon rate of 6 percent. What is the cost of equity?

Answer 1

Answer:

cost of equity is 11.60 %

Explanation:

Given data

cost of capital = 10.9 percent

tax rate = 35 percent

earnings = $21,800

bonds outstanding = $25,000

rate = 6 %

to find out

cost of equity

solution

we will find first value of unlevered

value of  unlevered  = earning ( 1 - tax rate ) / cost of capital

value of  unlevered  = 21800 ( 1 - 0.35 ) / 0.109 = $130000

so

value of  unlevered will be for firm = 130000 × bond outstanding × tax rate

value of  unlevered will be for firm = 130000 × 25000 × 35%

value of  unlevered will be for firm = $138750

so value of firm will be = bond outstanding + equity

so equity will be = 138750 - 25000

equity = $113750

so now

cost of equity will be = cost of capital + ( cost of capital - rate) (bonds / equity ) ( 1 - tax rate )

cost of equity will be = 10.9%+ ( 10.9 % - 6%) (25000 / 113750 ) ( 1-0.35)

so cost of equity = 11.60 %