Question

Brown Industries has a debt-equity ratio of 1.3. Its WACC is 8 percent, and its cost of debt is 5 percent. There is no corporate tax.

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-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 the nearest whole number, e.g., 32.)
b-2.	What would the cost of equity be if the debt-equity ratio were .6? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b-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 the nearest whole number, e.g., 32.)

Answer 1

D/A = D/(E+D)

D/A = 1.3/(1+1.3)

=0.5652

E/A = 1-D/A

=1-0.5652

=0.4348

a

WACC = Levered cost of equity*E/A+Cost of debt*(1-tax rate)*D/A

0.08= Levered cost of equity*0.4348+0.05*(1-0)*0.5652

Levered cost of equity =11.9%

b-1

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

0.119 = Unlevered cost of equity+1.3*(Unlevered cost of equity-0.05)*(1-0)

Unlevered cost of equity = 8

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 8+2*(8-5)*(1-0)

Levered cost of equity = 14

b-2

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 8+0.6*(8-5)*(1-0)

Levered cost of equity = 9.8

b-3

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 8+0*(8-0.05)*(1-0)

Levered cost of equity = 8