Question

Celebrity plc. has a target debt-equity ratio of 0.8. Its WACC is 10.5% and the tax rate is 35 per cent

(a) If the firm's cost of equity is 15 per cent what is its pre-tax cost of debt?

(b) If instead you know that the after-tax cost of debt is 6.4 per cent, what is the cost of equity?

Answer 1

Given D/E Ratio is 0.8 Hence debt value is 80 and Equity value is 100 and Total value D+E is 180

WACC is 10.5%

Tax rate is 35%

the weighted average cost of capital [WACC] =(E/V*Ke+D/V*Kd*(1-Tax Rate)

 

a)

if cost of equity is 15% what is pre tax cost of debt

10.5% = 100/180*15%+80/180*Kd*(1-T)

10.5% = 8.33%+0.44*Kd*(1-T)

0.44Kd(1-t) = 2.17%

Pre tax cost of debt =4.93%

 

b)

If pre tax cost of debt is 6.4% what is cost of equity

10.5% = 100/180*Ke+80/180*6.4%

0.55Ke = 10.5%-2.84%

Ke = 7.66%/0.55

cost of equity = 13.93%

a) Pre tax cost of debt =4.93%

 

b) Cost of equity = 13.93%