Unlevering the Equity Cost of CapitalLow Leverage & High Leverage Companies: Below, we show

the information for two potential comparable companies. Calculate the unlevered cost of capital based on the

following assumptions. Neither company expects its free cash flows to grow.

Low Leverage

Company

High Leverage

Company

Income tax rate for interest (T

INT

) ............................. 35.0% 45.0%

Value of debt ............................................ $ 4,000 $45,000

Value of preferred stock .................................... $ 1,000 $ 0

Value of equity ........................................... $15,000 $ 5,000

Maturity of debt (years) .................................... Perpetual Perpetual

Debt cost of capital ....................................... 5.0% 8.0%

Preferred stock cost of capital ............................... 6.0%

Equity cost of capital ...................................... 11.8% 28.0%

a. Assume that interest is tax deductible and that the discount rate for all interest tax shields is the unlevered

cost of capital.

b. Assume that interest is tax deductible and that the discount rate for all interest tax shields is the cost of debt.

c. Assume that interest is tax deductible but that the company refinances its debt at the end of each year

(annual refinancing)