Luther Industries has 25 million shares outstanding trading at $18 per share. In addition, Luther has $150 million in outstanding debt. Suppose Luther's equity cost of capital is 13%, its debt cost of capital is 7%, and the corporate tax rate is 21%. What is Luther's unlevered cost of capital
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Luther Industries has 25 million shares outstanding trading at $18 per share. In addition, Luther has $150 million in outstanding debt. Suppose Luther's equity cost of capital is 13%, its debt cost of capital is 7%, and the corporate tax rate is 21%.
What is Luther's unlevered cost of capital?
Formulae:-
Value of equity = number of outstanding shares * trading price.
Value of firm = value of equity + outstanding debt.
Weight of debt = outstanding debt / value of firm.
Weight of equity= value of equity / value of firm.
Unlevered cost of capital = ( Weight of debt * debt cost of capital) + (weight of equity * equity cost of capital)
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