The MD Manufacturing Company has $75m debt outstanding with pre-tax cost of 6% and its common stock has a value of $125m

Finance Apr 25, 2021

The MD Manufacturing Company has $75m debt outstanding with pre-tax cost of 6% and its common stock has a value of $125m. The levered cost of equity is 14.34%. The corporate tax rate is 35%. Assuming an MM (1963) tax world, calculate the unlevered cost of equity.

Expert Solution

Computation of Unlevered Cost of Equity:

Cost of Capital of Levered Firm = R0 +(Debt/ Equity)*(R0- Cost of Debt)*(1-Tax Rate)

Here,

Let R0 be the Unlevered cost of Equity.

So,

0.1434 = R0+($75 million /$125 millions)*(R0-0.06)(1-0.35)

0.1434 = R0 + 0.6*(R0-0.06)*0.65

0.1434 = R0 + 0.39*(R0-0.06)

0.1434 = R0 + 0.39*R0 - 0.0234

0.1434 + 0.0234 = 1.39*R0

0.1668 = 1.39*R0

R0 = 0.1668 / 1.39

R0 = 0.12 or 12%

So, Unlevered Cost of Equity is 12%.

Archived Solution

Unlocked Solution

You have full access to this solution. To save a copy with all formatting and attachments, use the button below.

Already a member? Sign In

Important Note: This solution is from our archive and has been purchased by others. Submitting it as-is may trigger plagiarism detection. Use it for reference only.

For ready-to-submit work, please order a fresh solution below.

Or get 100% fresh solution

Get Custom Quote