Aspen's Distributors has a cost of equity of 13.84% and an unlevered cost of capital of 12%. The company has $5,000 in debt that is selling at par value. The levered value of the firm is $12,000 and the tax rate is 34%. What is the pre-tax cost of debt?
A) 7.92%
B) 8.10%
C) 8.16%
D) 8.84%
E) 9.00%

Question

Quizplus · Accepted Answer

We can use the following formula to calculate the pre-tax cost of debt:

Levered Cost of Capital = Unlevered Cost of Capital + (Debt/Equity) * (Pre-tax cost of debt - Unlevered Cost of Capital) * (1 - Tax Rate)

Plugging in the given values, we get:

12% = 13.84% + (5,000/7,000) * (Pre-tax cost of debt - 12%) * (1 - 0.34)

Solving for Pre-tax cost of debt, we get:

Pre-tax cost of debt = 8.10% (rounded to the nearest hundredth)

Therefore, the best choice is B.

Aspen's Distributors Has a Cost of Equity of 13