Question

The Tip-Top Paving Co. wants to be levered at a debt to value ratio of .6. The cost of debt is 11%, the tax rate is 34%, and the cost of equity for an all equity firm is 14%. What will be Tip-Top's cost of equity?

Answer 1

Step-by-step explanation:

Tip-Top is a levered firm since it has debt in its capital structure. This question is asking for levered cost of equity.

The formula for levered cost of equity is as follows;

kL = kU + (kU - rD)*D/E

kL = levered cost of equity

kU = Unlevered cost of equity = 14% or 0.14 as a decimal

rD = cost of debt = 11% or 0.11 as a decimal

D + E = 0.6+ 0.4 = 1 (this represents the total value of the firm)

therefore D/E = 0.6/0.4 = 1.5

D/E = debt-equity ratio = 1.5

Next, plug in the numbers to the formula;

kL = 0.14 + ( 0.14 - 0.11)*1.5

kL = 0.14 + 0.045

kL = 0.185 or 18.5%

Therefore, cost of equity is 18.5%