The Tip-Top Paving Co. has an equity cost of capital of 16.97% The debt to value ratio is .6 and a cost of debt of 11%. What is the cost of equity if Tip-Top was unlevered?

Question

Quizplus · Accepted Answer

The cost of equity for an unlevered firm can be calculated using the Modigliani-Miller Proposition II without taxes, which states that the cost of equity for a levered firm (Re) is equal to the cost of equity for an unlevered firm (Ru) plus the debt-to-equity ratio (D/E) times the spread between the cost of equity for the levered firm and the cost of debt (Rd), i.e., Re = Ru + (D/E)(Re - Rd). Rearranging the formula to solve for Ru gives us Ru = Re - (D/E)(Re - Rd). Given that the debt to value ratio (D/V) is 0.6, we can find the equity to value ratio (E/V) as 1 - D/V = 1 - 0.6 = 0.4. The debt to equity ratio (D/E) is then D/V divided by E/V = 0.6 / 0.4 = 1.5. Plugging in the given values: Ru = 16.97% - (1.5)(16.97% - 11%) = 14.73%.