Question

You are opening a landscaping business, and wish to estimate your levered cost of equity. Beatrice's Yard Maintenance has an equity beta of 1.3, and a D/E ration of 0.8. If the riskless rate is 0.04, the expected return on the S&P500 is 0.14, and your firm will have a D/E ratio of 1, what would your firm's levered cost of equity be if the tax rate is 0.31? Please give your answer in the form of a decimal to 2 places - if your answer is 10.5%, please enter 0.105.

Answer 1

Levered Cost of Equity =Risk Free Rate+Beta*(Market return-Risk Free Rate) =0.04+1.3*(0.14-0.04) =17%
Levered Equity =Unlevered Equity+(Unlevered Equity-Cost of Debt)*Debt/Equity*(1-Tax Rate)
Levered Equity =Unlevered Equity+(Unlevered Equity-Cost of Debt)*Debt/Equity*(1-Tax Rate)
17%=Unlevered Equity+(Unlevered Equity-0.04)*0.8*(1-0.31)
17%=Unlevered Equity*(1+0.8*0.69)-0.04*0.8*0.69
Unlevered Equity =(17%+0.04*0.8*0.69)/(1+0.8*0.69)=12.3763%

Levered Cost of Equity at D/E ratio of 1 =Unlevered Equity+(Unlevered Equity-Cost of Debt)*Debt/Equity*(1-Tax Rate)
=12.3763%+(12.3763%-4%)*1*(1-0.31) =18.16%