Question

Weston Industries has a debt-equity ratio of 1.4. Its WACC is 11 percent, and its cost of debt is 9 percent. The corporate tax rate is 34 percent. (Do not include the percent signs (%). Round your answers to 2 decimal places. (e.g., 32.16))

a. Weston’s cost of equity capital is ____ percent.

b. Weston’s unlevered cost of equity capital is ____ percent.

c. The cost of equity would be _____ percent if the debt-equity ratio were 2, _____ percent if the debt-equity ratio were 1, and _____ percent if the debt-equity ratio were 0.

Answer 1

a.

D/A = D/(E+D)

D/A = 1.4/(1+1.4)

=0.5833

Weight of debt = D/A

Weight of debt = 0.5833

W(D)=0.5833

Weight of equity = 1-D/A

Weight of equity = 1-0.5833

W(E)=0.4167

WACC=after tax cost of debt*W(D)+cost of equity*W(E)

11=5.94*0.5833+cost of equity*0.4167

cost of equity = 18.083%

b.

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

18.083 = Unlevered cost of equity+1.4*(Unlevered cost of equity-9)*(1-0.34)

Unlevered cost of equity = 13.72

c.

D/E =2

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 13.72+2*(13.72-9)*(1-0.34)

Levered cost of equity = 19.95

D/E = 1

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 13.72+1*(13.72-9)*(1-0.34)

Levered cost of equity = 16.84

D/E = 0

Levered cost of equity = Unlevered cost of equity+D/E*( Unlevered cost of equity-cost of debt)*(1-tax rate)

Levered cost of equity = 13.72+0*(13.72-9)*(1-0.34)

Levered cost of equity = 13.72

b.

c.