Question

Brown Industries has a debt-equity ratio of 1.5. Its WACC is 9.6 percent, and its cost of debt is 5.7 percent. There is no corporate tax.

a. What is the company's cost of equity capital?

b-1. What would the cost of equity be if the debt-equity ratio were 2.0? and what if it were zero?

Answer 1

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

cost of debt = 5.7%,

debt - equity ratio = 1.50

This means that Debt / Equity = 1.50

Debt = 1.50 * equity

Total capital = Debt+ equity = 1.50 * equity + equity = 2.50 * equity

Equity weight = Equity / 2.50 Equity = 40%

Weight of debt = 100% - weight of equity = 100% - 40% = 60%

9.6% = 40% * cost of equity + 60% * 5.7%

Cost of equity = (9.6% - 3.42%) /0.4

= 15.45%

2)

If debt / equity = 2.0

Debt = 2* equity

Total capital = Debt+ equity = 2 * equity + equity = 3 * equity

Equity weight = Equity / 3 Equity = 33.33%

Weight of debt = 100% - weight of equity = 100% - 33.33% = 66.67%

9.6% = 33.33% * cost of equity + 66.67% * 5.7%

Cost of equity = (9.6% - 3.8%) /0.4 = 14.50%

When debt / equity = 0 this means that there is no debt and capital consists of 100% equity

WACC = weight of equity * cost of equity

9.6% = 100% * cost of equity

cost of equity = 9.6%