Question

Weston Industries has a debt-equity ratio of 1.7. Its WACC is 8.1 percent, and its cost of debt is 5.7 percent. The corporate tax rate is 23 percent.

  

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.	What is the company’s unlevered 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.)
c-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 2 decimal places, e.g., 32.16.)
c-2.	What would the cost of equity be if the debt-equity ratio were 1.0? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-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 2 decimal places, e.g., 32.16.)

Answer 1

(a) Debt to Equity Ratio = DE = 1.7, WACC = 8.1 %, Cost of Debt = 5.7 %, Tax Rate = 23 % and let the cost of equity capital be ke

Debt Proportion = D = Debt / (Debt + Equity) = 1.7 / (1.7 +1) = 1.7 / 2,7 = 0.62963 and Equity Proportion = E = 1-0.62963 = 0.37037

WACC = (1-Tax Rate) x D x Cost of Debt + E x Cost of Equity = (1-0.23) x 5.7 x 0.62963 + 0.37037 x ke

8.1 = 2.763446 + 0.37037 x ke

5.336554 / 0.37037 = ke

ke = 14.40871 % ~ 14.41 %

(b) Let the unlevered cost of equity capital be K

Therefore, Cost of Equity Capital = Unlevered Cost of Equity + DE x (1-tax rate) x (unlevered cost of equity - cost of debt) -(A)

14.41 = K + 1.7 x (1-0.23) x (5.7 - K)

14.41 = K + 1.309 x (K-5.7)

14.41 = K + 1.309K - 7.4613

2.309K = 14.41 + 7.4613 = 21.8713

K = 21.8713 / 2.309 = 9.472196 % ~ 9.47 %

(c1)

Using Equation (A), Cost of Equity Capital = 9.47 + (1-0.23) x 2 x (9.47 - 5.7) = 15.2758 % ~ 15.28 %

(c2) Using Equation (A), Cost of Equity Capital = 9.47 + (1-0.23) x 1 x (9.47 - 5.7) = 12.3729% ~ 12.37%

(c3) Using Equation (A), Cost of Equity Capital = 9.47 + (1-0.23) x 0 x (9.47 - 5.7) = 9.47 %