Question

Crosby Industries has a debt–equity ratio of 1.4. Its WACC is 9 percent, and its cost of debt is 4 percent. There is no corporate tax. What is the company’s cost of equity capital?What would the cost of equity be if the debt–equity ratio were 2? What would the cost of equity be if the debt–equity ratio were .5? What would the cost of equity be if the debt–equity ratio were zero?

Answer 1

WACC = [ weight of debt * cost of debt] + [weight of equity * cost of equity]

case 1:

debt to equity ratio = 1.4./1.

=>weight of debt = 1.4/(1.4+1)

=>1.4/2.4 =>0.58333.

weight of equity = 0.41667.

now,

WACC i.e 9% = [0.58333*4%] +[0..41667*weight of equity]

=> 9% =2.33332%+0.41667*weight of equity

=>9%-2.33332 = 0.41667*weight of equity

=>6.66668 / 0.41667 = weight of equity

=>16%.

case 2

debt to equity ratio =2/1

weight of debt = 2/(2+1) =>2/3 =>0.666667

weigth of equity =1/3=>0.333333

now,

WACC i.e 9% = [0.666667 * 4%] + [0.333333*cost of equity]

=>9% -2.666668% = 0.333333* cost of equity

=>6.3333332 / 0.333333 = cost of equity

=> cost of equity = 19%.

case 3

debt / equity ratio = 0.5/1

weight of debt = 0.5 /(1.5)

=>0.33333

weight of equity = 1 /(1.5)

=>0.66667

wacc i.e 9% = [0.33333*4%] + [0.66667* cost of equity]

=> 9%-1.33332% = 0.66667 * cost of equity

=>7.666668/0.66667 = cost of equity

=>11.5%.

cost of equity = 11.5%.

case 4

debt to equity ratio = 0/1

weight of debt = nil

weight of equity = 1

WACC = 9% =[nil * 4%] +[1* cost of equity]

=>9% = niil + cost of equity

=> cost of equity = 9%.