Question

Brown Industries has a debt-equity ratio of .9. Its WACC is 7 percent, and its cost of debt is 4 percent. There is no corporate tax.

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

b-1. What would the cost of equity be if the debt-equity ratio were 2? (Do not round intermediate calculations and enter your answer as a percent rounded to the nearest whole number, e.g., 32.)

b-2. What would the cost of equity be if the debt-equity ratio were .7? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

b-3. What would the cost of equity be if the debt-equity ratio were zero? (Do not round intermediate calculations and enter your answer as a percent rounded to the nearest whole number, e.g., 32.)

a: cost of equity :
b-1: cost of equity
b-2: cost of equity
b-3: cost of equity

Answer 1

Ans : Weighted Average Cost of Capital is average cost of capital the company is required to pay to all its security holders.

WACC = ( Equity proportion * Cost of Equity + Debt proportion * Cost of debt after tax )

a) Company's Cost of Equity if debt Equity ration is 0.9

Debt Equity ratio = 0.9
Debt = 0.9Equity

Step 1 : Computation of equity and debt proportion

Let equity capital be 1
Debt capital = 0.9*equity = 0.9*1 = 0.9

Value of Firm = Debt + Equity
Value of Firm = 1 + 0.9
Value of Firm = 1.9

Equity Proportion = 1 / 1.9 = 0.526 = ~0.53
Debt Proportion = 0.9 / 1.9 = 0.473 = ~0.47

Step 2 : Cost of Equity computation

WACC = ( Equity proportion * Cost of Equity + Debt proportion * Cost of debt after tax )
7% = (0.53 * Cost of Equity + 0.47 * 4%)
7% = 0.53Cost of Equity + 1.88%
0.53Cost of Equity = 5.12%
Cost of Equity = 9.66%

Ans : Cost of Equity Capital = 9.66%

b-1) Company's Cost of Equity if debt Equity ration is 2

Step 1 : Computation of Debt & Equity proportion

Let equity capital be 1
Debt capital = 2*equity = 2*1 = 2

Value of Firm = Debt + Equity
Value of Firm = 1 + 2
Value of Firm = 3

Equity Proportion = 1 / 3 = 0.333 = ~0.33
Debt Proportion = 2 / 3 = 0.666 = ~0.67

Step 2 : Cost of Equity computation

WACC = ( Equity proportion * Cost of Equity + Debt proportion * Cost of debt after tax )
7% = (0.33 * Cost of Equity + 0.67 * 4%)
7% = 0.33Cost of Equity + 2.68%
0.33Cost of Equity = 4.32%
Cost of Equity = 13.09%

Ans : Cost of Equity Capital = 13.09%

b-2) Company's Cost of Equity if debt Equity ration is 0.70

Step 1 : Computation of Debt & Equity proportion

Let equity capital be 1
Debt capital = 0.7*equity = 0.7*1 = 0.7

Value of Firm = Debt + Equity
Value of Firm = 1 + 0.7
Value of Firm = 1.7

Equity Proportion = 1 / 1.7 = 0.588 = ~0.59
Debt Proportion = 0.7 / 1.7 = 0.412 = ~0.41

Step 2 : Cost of Equity computation

WACC = ( Equity proportion * Cost of Equity + Debt proportion * Cost of debt after tax )
7% = (0.59 * Cost of Equity + 0.41 * 4%)
7% = 0.59Cost of Equity + 1.64%
0.59Cost of Equity = 5.36%
Cost of Equity = 9.08%

Ans : Cost of Equity Capital = 9.08%

b-3) Company's Cost of Equity if debt Equity ration is 0

Since there is no Debt the company is financed full by equity. Thus equity proportion will be 1

Cost of Equity Computation

WACC = ( Equity proportion * Cost of Equity + Debt proportion * Cost of debt after tax )
7 = (1 * Cost of Equity + 0*4%)
Cost of Equity = 7%


Ans : Cost of Equity = 7%