Al's Pub has debt with both a book and a market value of $120,000. This debt has a coupon rate of 9% and pays interest annually. The expected earnings before interest and taxes are $42,600, the
Tax rate is 34%, and the unlevered cost of capital is 11%. What is the ﬁrm's cost of equity?
A) 11.90%
B) 12.07%
C) 12.11%
D) 12.15%
E) 12.18%

Question

Quizplus · Accepted Answer

The correct answer is A because the firm's cost of equity is 11.90%. This can be calculated using the following formula:Cost of equity = Unlevered cost of capital + (Unlevered cost of capital - Tax rate) * (Debt / Equity)In this case, the unlevered cost of capital is 11%, the tax rate is 34%, and the debt-to-equity ratio is 120,000 / (42,600 * (1 - 0.34)) = 2.00. Plugging these values into the formula, we get:Cost of equity = 11% + (11% - 34%) * 2.00 = 11.90%

Al's Pub Has Debt with Both a Book and a Market