SWASH

in the case of an all equity company - D=0, E=1
so D/E = 0
So formula reduces to Re = R0
which is right.
If Schweser has the formula in that way, it is definitely incorrect.
R0 = D/D+E* Rd * (1-T) + E/D+E * Re
work back from there to arrive at Re formula
and you will get
Re = R0 + (Ro-Rd(1-T)) * D/E

ogoluwa

Suppose Re = 16%, Rd = 5%, Tax = 20% Debt to Asset ratio = 50%
WACC = 0.5 x 5(1-20%) + 0.5 x 16
WACC = 0.5 x 4 + 0.5 x 16
WACC = 2+8
WACC = 10%
Using the formula (incorrect)
Re = Ro + (Ro - Rd)(1-t) D/E
Re = 10 + (10 - 5)(1-20%) x 0.5/0.5
Re = 10 + 5(1-20%) x 1
Re = 10 + 4
Re = 14% (Which is wrong)
Using the correct formula as CPK mentioned
Re = Ro + (Ro - Rd(1-t)) x D/E
Re = 10 + (10 - 5(1-20%))x 0.5/0.5
Re = 10 + (10 - 4) x 1
Re = 10 + (6)
Re = 16% (Which is correct)

LokiDog2

be careful may friends,2 EOC Q are based on this wrong formula

lc26mizzou

Please! I remind that: CFA text book is no wrong!
You should read this link for more detail.
http://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theorem

sharksfan

bump

Chuckrox

Why’re you bumping this? It is just going to create more confusion for everyone.

IAmNeil

for all-equity : wacc=re=r0, Vu=[EBIT(1-t)]/r0
if finance with leverage,  Vl=Vu+tD=D+E=[EBIT(1-t)]/rwacc,  and  rwacc=(D/Vl)rd(1-t)+(E/Vl)re
== Vl*rwacc=rd*(1-t)*D+re*E
== EBIT(1-t)=rd*(1-t)*D+re*E
== Vu*r0=rd*(1-t)*D+re*E
== r0*(Vl-t*D)=rd*(1-t)*D+re*E
== r0*(D+E-t*D)=rd*(1-t)*D+re*E
== ro*(1-t)*D+r0*E=rd*(1-t)*D+re*E
== re=r0+(r0-rd)*(1-t)*(D/E)

mkytz15

Oh no not again. Aether, are we going to bother?

leadcfa

BrightStar wrote:
Oh no not again. Aether, are we going to bother?
LOL, exactly my thoughts.
Guys, quit bumping this thread… the formula given in the CFAI text is correct as given. No need for proofs or second-guessing the core material.