Question

11. 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

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

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

11% = {Cost of Equity * [Equity / (1 + Debt equity ratio)]} + {7% * (1 - 0.35) * [Debt / (1 + Debt equity ratio)]}

11% = {Cost of Equity * [1 / (1 + 1.5)]} + {7% * (1 - 0.35) * [1.5 / (1 + 1.5)]}

11% = {Cost of Equity * 0.40} + 2.73%

11% - 2.73% = Cost of Equity * 0.40

==> Cost of Equity = 8.27% / 0.40

= 20.675%

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

20.675% = Unlevered Cost of Equity + [(UnLevered Cost of equity - 7%) * 1.5 * (1 - 0.35)]

20.675% = Unlevered Cost of Equity + [(UnLevered Cost of equity - 7%) * 0.975]

20.675% = Unlevered Cost of Equity + 0.975UnLevered Cost of equity - 6.825%

20.675% + 6.825% = 1.975 Unlevered Cost of Equity

==> Unlevered Cost of Equity = 27.5 / 1.975

= 13.9240506329 % or 13.92%

(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)]

= 13.9240506329% + [(UnLevered Cost of equity - 7%) * 1 * (1 - 0.35)]

=13.9240506329% + [(13.9240506329 - 7%) * 0.65]

==> Cost of Equity = 18.42%

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)]

=13.9240506329% + [(13.9240506329% - 7%) * 2 * (1 - 0.35)]

= 13.9240506329% + [(13.9240506329% - 7%) * 1.3]

==> Cost of Equity = 22.93%

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)]

=13.9240506329% + [(UnLevered Cost of equity - 7%) * 0 * (1 - 0.35)]

= 13.9240506329% + [(13.9240506329% - 7%) *0]

==> Cost of Equity = 13.92%