Question

. Weston Industries has a debt-to-equity ratio of 1.5. Its WACC is 11 percent, and its cost of debt is 7 percent. The corporate tax rate is 35 percent. (Do not round intermediate calculations. Round the final answers to 2 decimal places.)

a. What is Weston’s cost of equity capital?

b. What is Weston’s unlevered cost of equity capital?

c-1. What would the cost of equity be if the debt-to-equity ratio were 2?

c-2. What would the cost of equity be if the debt-to-equity ratio were 1.0?

c-3. What would the cost of equity be if the debt-to-equity ratio were 0?

Answer 1

a) Ans: Debut equity ratio = Debt/ Equity =1.5

Suppose 1.5 boxes debt/ 1 boxes equity then total 2.5 therefore, weighted debt i.e.Wd = 1.5/2.5=0.6 and Weighted equity i.e.We= 1/2.5= 0.4

Now the WACC formula = We×Ke + Wd×Kd(1-0.35)

[Ke= cost of capital and Kd= Cost of debt]

Therefore,

0.11= 0.4×Ke +0.6× 0.07(0.65)

Or, 0.11= 0.4×Ke +0.042×0.65

Or, 0.11=0.4×Ke +0.0273

Or, 0.11-0.0273= 0.4×Ke

Or, 0.0827= 0.4×Ke

Or, 0.0827/0.4=Ke

Therefore, Ke=0.020675 or 0.02

Weston’s cost of equity capita is 0.02 or 0.02×100 =2%.

b) Generally, unlevered cost of equity =

Ru =(We×Ke) + (Wd×Kd)

=(0.4×0.02) + (0.6×0.07)

=0.008+0.042

=0.05

c-1) if debt-equity ratio 2

Another formula, D/E= 2

Or, 0.07/E=2

Or, 0.07=2×E

Or, 0.07/2=E=0.035

The cost of equity will be 0.035 or 3.5 %

C-2) if debt-equity ratio 1.0

Another formula, D/E= 1.0

Or, 0.07/E=1.0

Or, 0.07=1.0×E

Or, 0.07/1.0=E=0.07

The cost of equity will be 0.07 or 7 %

C-3) if debt-equity ratio 0

Another formula, D/E= 0

Or, 0.07/E=0

Or, 0.07=0×E

Or, 0.07/0=E=0

The cost of equity will be 0 or null.

Anything else you can ask me.