Question

Weston Industries has a debt–equity ratio of 1.7. Its WACC is 9.6 percent, and its pretax cost of debt is 7 percent. The corporate tax rate is 35 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.) Cost of equity capital %

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.) Cost of equity %

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.) Cost of equity %

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

D/A = D/(E+D)

D/A = 1.7/(1+1.7)

=0.6296

After tax cost of debt = cost of debt*(1-tax rate)

After tax cost of debt = 7*(1-0.35)

= 4.55

Weight of equity = 1-D/A

Weight of equity = 1-0.6296

W(E)=0.3704

Weight of debt = D/A

Weight of debt = 0.6296

W(D)=0.6296

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

9.6=4.55*0.6296+cost of equity*0.3704

cost of equity = 18.18%

b

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

18.18 = Unlevered cost of equity+1.7*(Unlevered cost of equity-7)*(1-0.35)

Unlevered cost of equity = 12.31

c1

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

Levered cost of equity = 12.31+2*(12.31-7)*(1-0.35)

Levered cost of equity = 19.21

c2

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

Levered cost of equity = 12.31+1*(12.31-7)*(1-0.35)

Levered cost of equity = 15.76

c3

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

Levered cost of equity = 12.31+0*(12.31-7)*(1-0.35)

Levered cost of equity = 12.31