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 1.5, and a D/E ration of 0.7. If the riskless rate is 0.04, the expected return on the S&P500 is 0.16, 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 0.28? 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+1.5*(0.16-0.04) =22%
Levered Equity =Unlevered Equity+(Unlevered Equity-Cost of Debt)*Debt/Equity*(1-Tax Rate)
22%=Unlevered Equity+(Unlevered Equity-0.04)*0.7*(1-0.28)
22%=Unlevered Equity*(1+0.7*0.72)-0.04*0.7*0.72
Unlevered Equity =(22%+0.04*0.7*0.72)/(1+0.7*0.72)=15.9681%

Levered Cost of Equity at D/E ratio of 1 =Unlevered Equity+(Unlevered Equity-Cost of Debt)*Debt/Equity*(1-Tax Rate)
=15.9681%+(15.9681%-4%)*1*(1-0.28) =24.59%