Question

Gilbert & Sons is a leveraged firm. It has 300,000 shares of stock outstanding with a market price of $32 per share. The company also has $6.6 million of debt outstanding that sells at par. The pre-tax cost of debt is 9 percent and the unlevered cost of capital is 12 percent. What is the cost of equity if the tax rate is 35 percent?

Answer 1

Answer:

13.34%

Explanation:

According to the MM theory :

re = ro + (ro - rd)(1-t)D/E

where re = cost of equity

ro = unlevered cost of capital

t = tax rate

d/e = debt to equity ratio

equity = 300,000 x $32 = $9,600,000

D/E = $6.6 million / $9.6 million = 0.6875

12% + (12% - 9%) x (1-0.35) x 0.6875 = 13.34%