Anderson's Furniture Outlet has an unlevered cost of capital of 8%, a tax rate of 35%, and expected earnings before interest and taxes of $1,500. The company has $3,500 in bonds outstanding that have a 5% coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

Question

Business

Fernanda Manning

Today, 12:39

Anderson's Furniture Outlet has an unlevered cost of capital of 8%, a tax rate of 35%, and expected earnings before interest and taxes of $1,500. The company has $3,500 in bonds outstanding that have a 5% coupon and pay interest annually. The bonds are selling at par value. What is the cost of equity?

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Mariam Lin · Answer 1

8.67%

Explanation:

The computation of cost of equity is shown below:-

Before capitalization the value of equity = Interest and taxes * (1 - tax rate) : Cost of capital

= $1,500 * (1 - 0.35) : 0.08

= $1,500 * 0.65 : 0.08

= $12,188

Value of firm with debt = The value of equity before capitalization + (Bonds outstanding * tax rate)

= $12,188 + ($3,500 * 0.35)

= $13,413

After recapitalization debt equity ratio = Cost of capital + ((Cost of capital - Coupon percentage) * Tax rate * (1 - tax rate)

= 0.08 + ((0.08 - 0.05) * (0.35) * (0.65))

= 0.08 + ((0.03) * (0.35) * (0.65))

= 8.67%