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Suppose that Rose Industries is considering the acquisition of another firm in its industry for $100 million.The acquisition is expected to increase Rose's free cash flow by $5 million the first year,and this contribution is expected to grow at a rate of 3% every year thereafter.Rose currently maintains a debt to equity ratio of 1,its corporate tax rate is 21%,its cost of debt rD is 6%,and its cost of equity rE is 10%.Rose Industries will maintain a constant debt-equity ratio for the acquisition.
-Rose's unlevered cost of capital is closest to:
A)8.0%.
B)7.5%.
C)7.0%.
D)9.0%.

Question

Quizplus · Accepted Answer

The unlevered cost of capital is the cost of capital for a firm with no debt. It is calculated as the weighted average cost of capital (WACC) with a debt-to-equity ratio of 0. In this case, the WACC is calculated as:WACC = (rD * D/V) + (rE * E/V)= (0.06 * 0.5) + (0.10 * 0.5)= 0.08Therefore, the unlevered cost of capital is 8%.

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