Question

A firm has a debt-equity ratio of .64, a cost of equity of 13.04 percent, and a cost of debt of 8 percent. Assume the corporate tax rate is 25 percent. What would be the cost of equity if the firm were all-equity financed

Answer 1

Answer:

11.41%

Explanation:

The cost of equity of an all-equity firm can be derived from the below formula:

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (1 - tax) * Debt-Equity Ratio

Levered Cost of Equity=13.04%

Unlevered Cost of Equity=the unknown(let us assume it is U)

cost of debt=8%

tax rate=25%

debt-equity ratio=0.64

13.04%=U+(U-8%)*(1-25%)*0.64

13.04%=U+(U-8%)*0.75*0.64

13.04%=U+(U-8%)*0.48

0.1304=U+0.48U-0.0384

0.1304+0.0384=1.48U

1.48U=0.1688

U=0.1688/1.48

U=11.41%