Deitweiler International has an unlevered cost of capital of 10%, a tax rate of 35%, and expected earnings before interest and taxes of $26,500. The company has $40,000 in bonds outstanding that have a 7% coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

A) 9.87%
B) 9.96%
C) 10.27%
D) 10.53%
E) 11.14%

Question

Matthew Hackett · Accepted Answer

Final Answer : D, Explanation :  The cost of equity can be calculated using the Modigliani-Miller Proposition II with taxes. The formula is: Cost of Equity = Unlevered Cost of Capital + (Unlevered Cost of Capital - Cost of Debt)(Debt/Equity)(1-Tax Rate). Given that the bonds are selling at par value, the market value of debt equals its book value ($40,000). To find the equity value, we need the firm's value (V = E + D). The firm's value can be calculated using the formula: V = EBIT(1-T) / Unlevered Cost of Capital = $26,500(1-0.35) / 0.10 = $172,250. Equity value (E) = V - D = $172,250 - $40,000 = $132,250. Plugging these values into the cost of equity formula gives: Cost of Equity = 10% + (10% - 7%)*($40,000/$132,250)*(1-0.35) = 10.53%.

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