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Q: finance ( Answered 5 out of 5 stars,   0 Comments )
Subject: finance
Category: Business and Money
Asked by: fatima1102-ga
List Price: $2.00
Posted: 10 Sep 2005 23:35 PDT
Expires: 10 Oct 2005 23:35 PDT
Question ID: 566671
Joes Manufacturing Company has $750 debt 
            outstanding with pretax cost of 6% and its common stock has a value 
            of $1,250. The required return on equity is 14.34%. The firm faces a 
            corporate tax rate of 35%. What is Monongahela's equivalent 
            unlevered cost of equity?
Subject: Re: finance
Answered By: omnivorous-ga on 11 Sep 2005 09:50 PDT
Rated:5 out of 5 stars
Fatima1102 ?

I hope that you?re reading these Answers in the order that they were
answered because the last question on Joe?s Manufacturing is critical
to answering this one:

According to Proposition 2 of the M&M theorem, the value of the firm
stays the same and costs of capital shift, as follows:

rE = r0 + D/E*(1-Tc)*(r0 - rD)

rE is the cost of equity
rD is the cost of debt
r0 is the cost of capital for an all-equity firm
D is the debt level
E is the equity level
Tc is the corporate tax rate
rWACC is a firm?s weighted average cost of capital. In a world with no
taxes, rWACC for a levered firm is equal to rA.

?M&M Proposition II,? (Harvey, Dec. 4, 1995)


Here?s what we know about Joe?s Manufacturing:

14.34% = r0 + $750/$1,250 * (0.65) * (r0 ? 6%)

14.34% = r0 + 0.39r0 ? 2.34%

16.68% = 1.39 r0

r0 = 12%

What?s important to remember here?  
1.	the value of the firm stays the same.
2.	your capital costs shift ? the cost of equity goes up because debt
is increasing the risk to shareholders (bond holders always get paid
first).  Also, the weighted-average cost-of-capital (WACC) goes down/
3.	the tax-deductibility of debt further reduces the WACC.

Google search strategy:
?Modigliani-Miller? proposition II

Best regards,

fatima1102-ga rated this answer:5 out of 5 stars

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