Question

Johnson Tire Distributors has debt with both a face and a market value of $35,000. This debt has a coupon rate of 6.6 percent and pays interest annually. The expected earnings before interest and taxes are $8,300, the tax rate is 21 percent, and the unlevered cost of capital is 10.9 percent. What is the cost of equity?

Answer 1

Answer:

11.25%

Explanation:

We use modigliani-miller proposition with taxes

Value unlevered: EBIT x (1 - tax-rate) / cost of equity

35,000 x (1 - 0.21) / 0.109 = 260.091,74

Value levered firm: unlevered + debt x tax-rate

260,091 + 35,000 x 0.21 = 267,441‬

Equity(levered firm):  267,441 - 35,000 = 232,441

Return on equity:

unlevered + difference between firm return and debt cost x weight of debt x after tax

0.109 + (10.9-0.08) x 35,000/232,441 x (1 - 0.21) = 0.112537027 = 11.25%