Question

Weston Industries has a debt–equity ratio of 1.2. Its WACC is 8.4 percent, and its cost of debt is 7.3 percent. The corporate tax rate is 35 percent.

a. What is the company’s cost of equity capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity capital            %

b. What is the company’s unlevered cost of equity capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Unlevered cost of equity capital            %

c-1 What would the cost of equity be if the debt–equity ratio were 2? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity            %

c-2 What would the cost of equity be if the debt–equity ratio were 1? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity            %

c-3 What would the cost of equity be if the debt–equity ratio were zero? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Cost of equity            %

Answer 1

a)

Weight of equity = 1 / (1 + 1.2) = 0.4545

Weight of debt = 1 - 0.4545 = 0.5455

WACC = weight of equity*cost of equity + after tax weight of debt*cost of debt

0.084 = 0.4545*cost of equity + 0.073*(1 - 0.35)*0.5455

0.058116 = 0.4545*cost of equity

Cost of equity = 0.1279 or 12.79%

b)

Cost of levered equity = cost of unlevered equity + (cost of unlevered levered equity - cost of debt)(1-tax)(debt-equity ratio)

0.1279 = cost of unlevered equity + (cost of unlevered levered equity -0.073)(1-0.35)1.2

0.1279 = cost of unlevered equity + 0.78cost of unlevered equity - 0.05694

cost of unlevered equity = 0.1038 or 10.38%

C-1)

If debt equity was 2:

Cost of levered equity = cost of unlevered equity + (cost of unlevered levered equity - cost of debt)(1-tax)(debt-equity ratio)

Cost of levered equity = 0.1038 + (0.1038 - 0.073)(1-0.35)2

Cost of levered equity = 0.1038 + 0.04404

Cost of equity = 0.1438 or 14.38%

c-2)

If debt equity was 1

Cost of levered equity = cost of unlevered equity + (cost of unlevered levered equity - cost of debt)(1-tax)(debt-equity ratio)

Cost of levered equity = 0.1038 + (0.1038 - 0.073)(1-0.35)1

Cost of levered equity = 0.1038 + 0.02002

Cost of equity = 0.1238 or 12.38%

c-3)

If debt equity was 0

Cost of levered equity = cost of unlevered equity + (cost of unlevered levered equity - cost of debt)(1-tax)(debt-equity ratio)

Cost of levered equity = 0.1038 + (0.1038 - 0.073)(1-0.35)0

Cost of levered equity = 0.1038 + 0

Cost of equity = 0.1038 or 10.38%