Question

Starset, Inc., has a target debt-equity ratio of 0.89. Its WACC is 10.5 percent, and the tax rate is 33 percent.

     

If the company's cost of equity is 14 percent, what is the pretax cost of debt?

If instead you know that the aftertax cost of debt is 5.6 percent, what is the cost of equity?

Answer 1

Starset, Inc., has a target debt-equity ratio of 0.89. Its WACC is 10.5 percent, and the tax rate is 33 percent.

If the company's cost of equity is 14 percent, what is the pretax cost of debt?

If instead you know that the aftertax cost of debt is 5.6 percent, what is the cost of equity?

- Target Debt/Equity = 0.89/1

So, Debt = 0.89

Equity = 1

Total capital Structure = Debt + Equity

= 0.89 + 1 = 1.89

- WACC = 10.5%

a). Company's Cost of equity = 14%

Calculating the Pre-tax cost of Debt using WACC formula:-

WACC= (Weight of Debt)(Before-Tax Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

10.5% = (0.89/1.89)(Before-Tax Cost of Debt)(1-0.33) + (1/1.89)(14%)

10.5% = (0.315503)(Before-Tax Cost of Debt) + 7.407407%

3.0926% = (0.315503)(Before-Tax Cost of Debt)

Before-Tax Cost of Debt = 9.80%

b). After-tax cost of Debt = 5.6%

WACC= (Weight of Debt)(After-Tax Cost of Debt) + (Weight of Equity)(Cost of Equity)

10.5% = (0.89/1.89)(5.6%) + (1/1.89)(Cost of Equity)

10.5% = 2.63704% + 0.5291(Cost of Equity)

Cost of Equity = 14.86%

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