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 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?```
 ```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: http://answers.google.com/answers/threadview?id=566672 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. WWWFinance ?M&M Proposition II,? (Harvey, Dec. 4, 1995) http://www.duke.edu/~charvey/Classes/ba350/capstruc/capstruc.htm JOE?S WITH DEBT =============== 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, Omnivorous-GA```