Question

Compass Corporation has a cost of equity of 11.8 percent and a pretax cost of debt of 7.5 percent. The debt-equity ratio is 1.70 and the tax rate is 25 percent. What is the unlevered cost of capital?

Answer 1

The unlevered cost of capital is the implied rate of return which a company expects to earn on its assets, without the effect of debt. In other words, it is the theoretical cost of a company financing itself considering the company has no debt.

Following information are given in question:

Cost of Capital = 11.8%

Cost of debt (pre tax) = 7.5%

Debt equity ratio = 1.70

Tax rate = 25%

Let Unlevered Cost of capital be X;

Cost of capital = Unlevered cost of capital + (Unlevered cost of capital - cost of debt (pre tax))*(debt equity ratio * (1-tax rate)

11.8% = X+(X-7.5%)*(1.70*(1-25%)) =

11.8% = X+(X-7.5%)*1.28

11.8% = X+1.28X-9.56

11.8% = 2.28X-9.56

2.28X = 11.8+9.56 = 21.36

X = 21.36/2.28 = 9.39%

Thus, Cost of unlevered capital = 9.39%