Answer:
14.143%
Explanation:
Data provided in the question:
market value of debt = $3,000
Coupon rate, r = 7% = 0.07
Expected earnings before interest and taxes = $1,200
Tax rate = 34% = 0.34
The unlevered cost of capital, Ra = 12% = 0.12
Now,
Value of firm = VU + Tax
Here
VU = [expected earnings before interest and taxes( 1 - t )] ÷ [ Ra ]
= [$1,200 ( 1 - 0.34)] ÷ 0.12
= $6,600
Thus,
Value of firm = $6,600 + ( $3,000 × 0.34 )
= $6,600 + 1,020
= $7,620
Thus,
Equity = Value of firm - Debt
= $7,620 - $3,000
= $4,620
Therefore,
Cost of equity = Ra + [ (Debt ÷ Equity ) × (1 - t ) × (Ra - r ) ]
= 0.12 + [ (3,000 ÷ 4,620) × (1 – 0.34) × (0.12 - 0.07) ]
= 0.14143
or
= 0.14143 × 100%
= 14.143%
