Salmon Inc. has debt with both a face and a market value of $227,000. This debt has a coupon rate of 7 percent and pays interest annually. The expected earnings before interest and taxes is $87,200, the tax rate is 35 percent, and the unlevered cost of capital is 12 percent. What is the firm's cost of equity

14.27%

Explanation:

Unlevered value = [Expected earnings before interest and taxes * (1 - tax rate) ]/Unlevered cost of capital

Unlevered value = [$87,200 x (1 - 0.35) ]/0.12 = $472,333.33

Levered value = Unlevered value + (Tax rate * Debt market value)

Levered value = $472,333.33 + (0.35 x $227,000) = $551,783.33

Value of equity = Levered value - Debt market value

Value of equity = $551,783.33 - $227,000 = $324,783.33

Cost of equity = Unlevered cost of capital + [ (unlevered cost of capital - coupon rate) * (Debt market value/Value of equity) * (1 - Tax rate) ]

Cost of equity = 0.12 + [ (0.12 - 0.07) * ($227,000/$324,783.33) * (1 - 0.35) ] = 0.1427, or 14.27%

Therefore, the firm's cost of equity is 14.27%