Elephant Inc., a zero growth firm, has an expected EBIT of $100,000 and a corpor

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Explanation / Answer

EBIT: $100,000 r d : 12% T c : 30% Debt: $500,000 r sU : 16%

V U = EBIT(1 – T)/r sU = $100,000(0.7)/0.16 = $437,500

V L = V U + TD = $437,500 + 0.3($500,000) = $587,500  

Note that the leveraged value of the firm is $587,500. The firm has $500,000 of debt. Therefore, the value of its equity must be $87,500. Using these data, we find the leveraged cost of equity as follows: r sL = r sU + (r sU – r d )(1 – T)(D/S) = 16% + (16% – 12%)(0.7)($500,000/$87,500) = 32.0%

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