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Unformatted text preview: $1,500,000 worth of equity, what is the new cost of equity? Re = Ra + (Ra-Rd)(D/E) = .12 + (.12-.06)(2/1) = .24 A stock buyback increases leverage similar to increasing debt levels. This causes the stock return to rise because of the increase in risk. 2d. If the firm in 2a above issues more stock so that its debt equity ratio is .5, what is the new cost of equity for the firm? Re = Ra + (Ra-Rd)(D/E) = .12 + (.12-.06)(.5) = .15 An increase in financing thru stock has less risk than paying off bondholders first. The final result is that the cost of equity is lower than the original case. 3. What is the cost of equity for a firm if the unlevered return (no debt) is 7%, the cost of debt is 5%, the debt equity ratio is 1 and the tax rate is 30 percent? Re = Ru + (Ru-Rd)(D/E)(1-T) = .07 + (.07-.05)(1)(1-.30) = .07 + .02(.7) = .084...
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This note was uploaded on 09/30/2008 for the course BUAD 306 taught by Professor Selvili during the Spring '07 term at USC.
- Spring '07