Question

Maxwell Industries has a debt–equity ratio of 1.5. WACC is 10 percent, and its cost of debt is 7 percent. The corporate tax rate is 35 percent. a. What is the company’s cost of equity capital? b. What is the company’s unlevered cost of equity capital? c. What would the cost of equity be if the debt–equity ratio were 2? What if it were 1.0? What if it were zero? ( kindly can u explain why are we using wacc equation in question a and why not in question c?)

Answer 1

Answer : (a.)Calculation of Cost of Equity Capital :

WACC = (Cost of Equity * Weight of Equity) + (Cost of After tax debt * Weight of Debt)

10% = {Cost of Equity * [Equity / (1 + Debt equity ratio)]} + {7% * (1 - 0.35) * [Debt / (1 + Debt equity ratio)]}

10% = {Cost of Equity * [1 / (1 + 1.5)]} + {7% * (1 - 0.35) * [1.5 / (1 + 1.5)]}

10% = {Cost of Equity * 0.40} + 2.73%

10% - 2.73% = Cost of Equity * 0.40

==> Cost of Equity = 7.27% / 0.40

= 18.175%

(b.) Company's Levered Cost of Equity = Unlevered Cost of Equity + [(UnLevered Cost of equity - Cost of Debt) * Debt Equity ratio * (1 - Tax rate)]

18.175% = Unlevered Cost of Equity + [(UnLevered Cost of equity - 7%) * 1.5 * (1 - 0.35)]

18.175% = Unlevered Cost of Equity + [(UnLevered Cost of equity - 7%) * 0.975]

18.175% = Unlevered Cost of Equity + 0.975UnLevered Cost of equity - 6.825%

18.175% + 6.825% = 1.975 Unlevered Cost of Equity

==> Unlevered Cost of Equity = 25 / 1.975

= 12.6582278481 % or 12.66%

(c.) Debt equity ratio is 1

Cost of Equity = Unlevered Cost of Equity + [(UnLevered Cost of equity - Cost of Debt) * Debt Equity ratio * (1 - Tax rate)]

= 12.6582278481% + [(UnLevered Cost of equity - 7%) * 1 * (1 - 0.35)]

=12.6582278481 + [(12.6582278481 - 7%) * 0.65]

==> Cost of Equity = 16.34%

Debt Equity Ratio is 2

Cost of Equity = Unlevered Cost of Equity + [(UnLevered Cost of equity - Cost of Debt) * Debt Equity ratio * (1 - Tax rate)]

=12.6582278481% + [(UnLevered Cost of equity - 7%) * 2 * (1 - 0.35)]

= 12.6582278481% + [(12.6582278481% - 7%) * 1.3]

==> Cost of Equity = 20.01%

Debt Equity Ratio is 0

Cost of Equity = Unlevered Cost of Equity + [(UnLevered Cost of equity - Cost of Debt) * Debt Equity ratio * (1 - Tax rate)]

=12.6582278481% + [(UnLevered Cost of equity - 7%) * 0 * (1 - 0.35)]

= 12.6582278481% + [(12.6582278481% - 7%) *0]

==> Cost of Equity = 12.66%

In part a we use WACC because WACC includes both component cost of equity and cost of debt with defined weights. But in c it calls for calculation of which is required to be calcuted with ullevered cost of equity (unlevered means no debt so we cannot se WACC equation)