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