Question

Eastern Townships Limited currently has no debt. Their cost of borrowing is 7%. The firm’s cost of capital is currently 10.5% and the tax rate is 40%. There are no costs of financial distress.

1. a) What is the company’s cost of equity?

2. b) If the firm converts to 35% debt, what will it’s cost of equity be?

3. c) If the firm converts to 45% debt, what will it’s cost of capital (WACC) be?

Answer 1

Answer a.

Unlevered Cost of Equity = 10.50%

Answer b.

Weight of Debt = 0.35

Weight of Equity = 1 - Weight of Debt
Weight of Equity = 1 - 0.35
Weight of Equity = 0.65

Debt-Equity Ratio = Weight of Debt / Weight of Equity
Debt-Equity Ratio = 0.35 / 0.65
Debt-Equity Ratio = 0.53846

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (1 - Tax Rate) * Debt-Equity Ratio
Levered Cost of Equity = 0.1050 + (0.1050 - 0.0700) * (1 - 0.40) * 0.53846
Levered Cost of Equity = 0.1050 + 0.0113
Levered Cost of Equity = 0.1163 or 11.63%

Answer c.

Weight of Debt = 0.45

Weight of Equity = 1 - Weight of Debt
Weight of Equity = 1 - 0.45
Weight of Equity = 0.55

Debt-Equity Ratio = Weight of Debt / Weight of Equity
Debt-Equity Ratio = 0.45 / 0.55
Debt-Equity Ratio = 0.81818

Levered Cost of Equity = Unlevered Cost of Equity + (Unlevered Cost of Equity - Cost of Debt) * (1 - Tax Rate) * Debt-Equity Ratio
Levered Cost of Equity = 0.1050 + (0.1050 - 0.0700) * (1 - 0.40) * 0.81818
Levered Cost of Equity = 0.1050 + 0.0172
Levered Cost of Equity = 0.1222 or 12.22%

Cost of Capital = Weight of Debt * Cost of Debt * (1 - Tax Rate) + Weight of Equity * Levered Cost of Equity
Cost of Capital = 0.45 * 7.00% * (1 - 0.40) + 0.55 * 12.22%
Cost of Capital = 1.89% + 6.72%
Cost of Capital = 8.61%