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27 July, 20:57

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?

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  1. 27 July, 21:09
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    Firm L's cost of equity is 13.2%

    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%
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