Question

QUESTION 32 Eccles Inccorporated Eccles Incorporated, a zero growth firm, has an expected EBIT of $100,000 and a corporate tax rate of 25%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. Refer to the data for Eccles Incorporated. What is the firm's cost of equity according to MM with corporate taxes

Answer 1

Answer:

The cost of equity is 32%

Explanation:

The formula for calculating firm's cost of equity according Miller and Modgiliani is given as:

r levered=r unlevered+(debt/equity*(r unlevered -cost of debt)*(1-tax)

r unlevered is the cost of an unlevered equity=16%

debt=$500000

cost of debt=12%

equity=unknown

Hence we need to first of all calculate the total value of the firm and the formula is

EBIT(1-tax)/unlevered cost of equity+(debt*tax)

$100000(1-0.25)/16%+($500000*25%)=$593750

r levered=16%+($500000/($593750-$500000)*(16%-12%)*(1-0.25)

r levered=0.32 that is 32%