Johnson Tire Distributors has debt with both a face and a market value of $12,000. This debt has a coupon rate of 6 percent and pays interest annually. The expected earnings before interest and taxes are $2,100, the tax rate is 30 percent, and the unlevered cost of capital is 11.7 percent. What is the firm's cost of equity?

a. 22.46 percent
b. 22.87 percent
c. 23.20 percent
d. 23.59 percent
e. 25.14 percent

Option (c) is correct.

Explanation:

Given that,

Face and market value of debt = $12,000

Coupon rate = 6 percent

Earnings before interest and taxes(EBIT) = $2,100

Tax rate = 30%

Unlevered cost of capital = 11.7%

Value of unlevered firm (VU):

= EBIT × (1-Tax) ÷ Cost

= [$2,100 × (1 - 0.3)] ÷ 0.117

= $1,470 ÷ 0.117

= $12,564.10

Value of levered firm:

= Value of unlevered firm + (Tax × Market value of debt )

= $12,564.10 + (0.30 × $12,000)

= $16,164.10

Value of equity:

= Value of levered firm - Debt

= $16,164.10 - $12,000

= $4,164.10

Return on Equity:

= Unlevered cost of capital + [(Unlevered cost - Coupon rate) × (Debt ÷ Value of equity) × (1 - Tax)]

= 0.117 + [(0.117 - 0.06) × ($12,000 ÷ $4,164.10) × (1 - 0.3)]

= 0.2320, or 23.20 %

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