Johnson Tire Distributors has an unlevered cost of capital of 12 percent, a tax
ID: 2680414 • Letter: J
Question
Johnson Tire Distributors has an unlevered cost of capital of 12 percent, a tax rate of 34 percent, and expected earnings before interest and taxes of $1,900 in perpetuity. The company has $3,400 in bonds outstanding that have a 7 percent coupon and pay interest annually in perpetuity. The bonds are selling at par value. What is the cost of equity?HINT: First get the value of the unlevered firm. Then get the value of the levered firm. Next, get the debt-equity ratio so you can calculate the cost of equity. Here you need both M&M propositions.
13.37 percent
10.69 percent
8.02 percent
12.03 percent
9.36 percent
Please show calculations!
Explanation / Answer
(8.02 percent ) The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing: Weighted Average Cost Of Capital (WACC) Where: Re = cost of equity Rd = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate
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