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16 October, 16:03

Salmon Inc. has debt with both a face and a market value of $3,000. This debt has a coupon rate of 7% and pays interest annually. The expected earnings before interest and taxes is $1,200, the tax rate is 34%, and the unlevered cost of capital is 12%. What is the firm's cost of equity?

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  1. 16 October, 16:18
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    14.143%

    Explanation:

    Data provided in the question:

    market value of debt = $3,000

    Coupon rate, r = 7% = 0.07

    Expected earnings before interest and taxes = $1,200

    Tax rate = 34% = 0.34

    The unlevered cost of capital, Ra = 12% = 0.12

    Now,

    Value of firm = VU + Tax

    Here

    VU = [expected earnings before interest and taxes (1 - t) ] : [ Ra ]

    = [$1,200 (1 - 0.34) ] : 0.12

    = $6,600

    Thus,

    Value of firm = $6,600 + ($3,000 * 0.34)

    = $6,600 + 1,020

    = $7,620

    Thus,

    Equity = Value of firm - Debt

    = $7,620 - $3,000

    = $4,620

    Therefore,

    Cost of equity = Ra + [ (Debt : Equity) * (1 - t) * (Ra - r) ]

    = 0.12 + [ (3,000 : 4,620) * (1 - 0.34) * (0.12 - 0.07) ]

    = 0.14143

    or

    = 0.14143 * 100%

    = 14.143%
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