Lamey Co. has an unlevered cost of capital of 10.9 percent, a tax rate of 35 percent, and expected earnings before interest and taxes of $21,800. The company has $25,000 in bonds outstanding that sell at par and have a coupon rate of 6 percent. What is the cost of equity?

cost of equity is 11.60 %

Explanation:

Given data

cost of capital = 10.9 percent

tax rate = 35 percent

earnings = $21,800

bonds outstanding = $25,000

rate = 6 %

to find out

cost of equity

solution

we will find first value of unlevered

value of unlevered = earning (1 - tax rate) / cost of capital

value of unlevered = 21800 (1 - 0.35) / 0.109 = $130000

so

value of unlevered will be for firm = 130000 * bond outstanding * tax rate

value of unlevered will be for firm = 130000 * 25000 * 35%

value of unlevered will be for firm = $138750

so value of firm will be = bond outstanding + equity

so equity will be = 138750 - 25000

equity = $113750

so now

cost of equity will be = cost of capital + (cost of capital - rate) (bonds / equity) (1 - tax rate)

cost of equity will be = 10.9% + (10.9 % - 6%) (25000 / 113750) (1-0.35)

so cost of equity = 11.60 %