Leverage [6]

A firm has expected net operating income (X) of $600. Its value as an unlevered firm (Vu) is $2,000. The firm is facing a tax rate of 40%. Suppose the firm changes it ratio of debt to equity ratio to equal 1. The cost of debt capital in this situation is 10%. Use the MM propositions to:

1. Calculate the after-tax cost of equity capital for both the levered and the unlevered firm.

2. Calculate the after-tax weighed average cost of capital for each.

3. Why is the cost of equity capital higher for the levered firm, but the weighted average cost of capital lower?