Answer:
14.27%
Explanation:
Unlevered value = [Expected earnings before interest and taxes × (1- tax rate)]/Unlevered cost of capital
Unlevered value = [$87,200 x (1- 0.35)]/0.12 = $472,333.33
Levered value = Unlevered value + (Tax rate × Debt market value)
Levered value = $472,333.33 + (0.35 x $227,000) = $551,783.33
Value of equity = Levered value - Debt market value
Value of equity = $551,783.33 - $227,000 = $324,783.33
Cost of equity = Unlevered cost of capital + [(unlevered cost of capital - coupon rate) × (Debt market value/Value of equity) × (1 - Tax rate)]
Cost of equity = 0.12 + [(0.12 - 0.07) × ($227,000/$324,783.33) × (1 - 0.35)] = 0.1427, or 14.27%
Therefore, the firm's cost of equity is 14.27%
