Question

Firm L has debt with a market value of $200,000 and a yield of 9%. The firm's equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L's cost of equity?

Answer 1

Firm L's cost of equity is 13.2%

Step-by-step explanation:

In order to calculate Firm L's cost of equity we would have to calculate the following formula:

Firm L's cost of equity=Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

D/E = debt/equity

D/E = $200,000/$300,000

D/E=0.6666

Therefore, Firm L's cost of equity= 12%+0.6666*(12%-9%)*(1-0.4)

Firm L's cost of equity=13.2%

Firm L's cost of equity is 13.2%