Question

Weston Industries has a debt-equity ratio of 1.4. Its WACC is 8.4 percent, and its cost of debt is 6.1 percent. The corporate tax rate is 21 percent.

  

a.	What is the company’s cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b.	What is the company’s unlevered cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-1.	What would the cost of equity be if the debt-equity ratio were 2? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-2.	What would the cost of equity be if the debt-equity ratio were 1.0? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-3.	What would the cost of equity be if the debt-equity ratio were zero? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Solution:
a.	Cost of Equity = 13.41%
Working Notes:
	debt equity ratio = 1.40
	Weight of Debt (D/V)= 1.4/ (1 + 1.4) =1.4/2.4
	Weight of Equity (E/V)= 1 / (1 + 1.4) =1/2.4
	WACC = (E/V)Ke + (D/V) (1 –Tax rate) Kd
	8.4 % = (1 /2.4) x Ke + (1.4 /2.4) x 6.1% x ( 1 -0.21)
	Ke = (8.4% - 2.81108333%) x 2.4
	Ke = 0.134134
	Ke=13.4134% = 13.41%
b.	Unlevered cost of equity capital =9.57%
Working Notes:
	RS= R0+ (R0-RB)(B/S)(1 -Tc)
	(B/S) = Debt-equity ratio = 1.40
	RS is cost of equity capital = 13.4134%
	R0 is cost of equity capital of unlevered firm = ??
	RB is Cost of Borrowing = 6.1%
	Tc = tax rate = 21%
	RS= R0+ (R0-RB)(B/S)(1 -Tc)
	13.4134% =R0+ (R0 - 6.1%)(1.4)(1 - 0.21)
	13.4134% =R0+ R0 x 1.106 - 6.7466%
	R0 = (13.4134% + 6.7466%)/2.106
	R0 = 20.16%/2.106
	R0 =9.57264957%
	R0 = 9.57%
C-1.	Cost of Equity =15.06%
Working Notes:
	cost of equity be if the debt−equity ratio were 2
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS is cost of equity capital    ??
	R0 is cost of equity capital of unlevered firm =9.57264957%
	RB is Cost of Borrowing = 6.1%
	B/S= Debt equity ratio = 2
	Tc = tax rate = 21%
	RS=R0+ (R0-RB)(B/S)(1 -Tc)
	RS= 9.57264957%+ (9.57264957% - 6.1%)(2)(1 -.21)
	RS= 9.57264957% + 5.48678632%
	RS= 15.05944%
	RS= 15.06%
C-2.	Cost of Equity = 12.32%
Working Notes:
	Cost of equity be if the debt−equity ratio were 1
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS is cost of equity capital    ??
	R0 is cost of equity capital of unlevered firm =9.57264957%
	RB is Cost of Borrowing =6.1%
	B/S= Debt equity ratio = 1
	Tc = tax rate = 21%
	RS=R0+ (R0-RB)(B/S)(1 -Tc)
	RS= 9.57264957%+ (9.57264957% - 6.1%)(1)(1 -.21)
	RS= 9.57264957%+ 2.7433932%
	RS=12.316043
	RS= 12.32%
C-3.	Cost of Equity = 9.57 %
Working Notes:
	cost of equity be if the debt−equity ratio were zero
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS is cost of equity capital    ??
	R0 is cost of equity capital of unlevered firm =9.57264957%
	RB is Cost of Borrowing = 6.1%
	B/S= Debt equity ratio = 0
	Tc = tax rate = 21%
	RS=R0+ (R0-RB)(B/S)(1 -Tc)
	RS= 9.57264957%+ (9.57264957% - 6.1%)(0)(1 -.21)
	RS= 9.57264957%+ 0
	RS= 9.57264957%
	RS= 9.57%
Please feel free to ask if anything about above solution in comment section of the question.