Question

Can you please provide a step by step instruction to get to the answer to the following question WACC. Kose, Inc., has a target debt-equity ratio of .38. Its WACC is 10.1 percent and the tax rate is 25 percent. a) If the company’s cost of equity is 12 percent, what is its pretax cost of debt? b) If instead you know that the aftertax cost of debt is 6.4 percent, what is the cost of equity?

Answer 1

Weighted average cost of capital (WACC) = [(S/S+B)*Rs + (B/S+B)*Rb(1-tc)]
	S = equity, B = debt, Rs = Cost of equity, Rb = cost of debt,
	tc = corporations tax rate
a)	Rs	0.12
	WACC	0.101
	tc	0.25
	B/S	0.38
	B	.38S
	S+B	1.38S
	S/(S+B)	S/1.38S
	S/(S+B)	0.7246
	B/(S+B)	1 - (S/(S+B))
	B/(S+B)	0.2754
	0.101	.7246*.12 + .2754*Rb*(1-.25)
	0.101	.7246*.12 + .2754*Rb*(.75)
	.2754*Rb*(.75) = .101 - (.7246*.12)
	.20655*Rb = .014048
	Rb = .014048/.20655
	Rb = .068
	The pre-tax cost of debt is equal to 6.8%.
b)	Rb*(1-tc)	0.064
	WACC	0.101
	B/S	0.38
	B	.38S
	S+B	1.38S
	S/(S+B)	S/1.38S
	S/(S+B)	0.7246
	B/(S+B)	1 - (S/(S+B))
	B/(S+B)	0.2754
	0.101	.7246*Rs + .2754*.064
	.7246*Rs+0.017626	0.101
	.7246*Rs	0.0833744
	Rs	.0833744/.7246
	Rs	0.115062655
	Rs	11.51%
	The cost of equity is equal to 11.51%.