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6 November, 18:19

The Tip-Top Paving Co. wants to be levered at a debt to value ratio of. 6. The cost of debt is 11%, the tax rate is 34%, and the cost of equity for an all equity firm is 14%. What will be Tip-Top's cost of equity?

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  1. 6 November, 18:37
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    Tip-Top is a levered firm since it has debt in its capital structure. This question is asking for levered cost of equity.

    The formula for levered cost of equity is as follows;

    kL = kU + (kU - rD) * D/E

    kL = levered cost of equity

    kU = Unlevered cost of equity = 14% or 0.14 as a decimal

    rD = cost of debt = 11% or 0.11 as a decimal

    D + E = 0.6 + 0.4 = 1 (this represents the total value of the firm)

    therefore D/E = 0.6/0.4 = 1.5

    D/E = debt-equity ratio = 1.5

    Next, plug in the numbers to the formula;

    kL = 0.14 + (0.14 - 0.11) * 1.5

    kL = 0.14 + 0.045

    kL = 0.185 or 18.5%

    Therefore, cost of equity is 18.5%
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