Question

Please solve it on excel

Torp Industries has a debt-equity ratio of 1.5. Its WACC is 12%, and its cost of debt is 12%. The corporate tax rate is 35%

a. What is Torp’s cost of equity capital?

b. What would the cost of equity be if the debt-equity ratio were 2? What if it were 1?

Answer 1

This means the  proportion of debt in total capital structure =

and proportion of equity in total capital structure =

WACC = 12 %

cost of debt = 12 %

WACC= We​∗Re + Wd​∗Rd
Where,
Re = cost of equity
Rd = cost of debt
We = Weight of equity in total capital structure
Wd = Weight of debt in total capital structure

a)

Solving this equation,

Re = 12%

Return on equity = 12 %

b) if the debt-equity ratio were 2.

This means the  proportion of debt in total capital structure =

and proportion of equity in total capital structure =

WACC = 12 %

cost of debt = 12 %

WACC= We​∗Re + Wd​∗Rd

Solving this equation,

Re = 12 %

b) if the debt-equity ratio were 1.

Proportion of debt = 1/2

Proportion of equity = 1/2

WACC = 12 %

cost of debt = 12 %

WACC= We​∗Re + Wd​∗Rd

solving this equation, we will get Re= 12 %.

As the cost of debt and WACC are equal with any combination of debt and equity, cost of equity will be 12 % only.

even if it is total equity portfolio, WACC will be 12 % or if total debt portfolio WACC will be 12 % only.

Hope it clarifies!