Question

Weston Industries has a debt-equity ratio of .8. Its WACC is 9.4 percent, and its cost of debt is 6.3 percent. The corporate tax rate is 25 percent.

What is the company’s cost of equity capital, unlevered cost of equity capital, cost of equity be if the debt-equity ratio were 2, 1, and 0?

Answer 1

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Answer:

a.
	Cost of equity capital
	debt equity ratio = 0.8
	Weight of Debt = 0.80/ (1 +0.80) =0.80/1.8
	Weight of Equity = 1 / (1 + 0.80) =1/1.8
	WACC = (E/V)Ke + (D/V) (1 –Tax rate) Kd
	9.4 % = (1 /1.8) x Ke + (0.8 /1.8) x 6.3% x ( 1 -0.25)
	Ke = (9.4% - 2.1%) x 1.8
	Ke = 13.14%
b.	Unlevered Cost of equity capital
:
	RS= R0+ (R0–RB)(B/S)(1 –Tc)
	(B/S) = Debt-equity ratio = 0.80
	RS is cost of equity capital = 13.14%
	R0 is cost of equity capital of unlevered firm = ??
	RB is Cost of Borrowing = 6.3%
	Tc = tax rate = 25%
	RS= R0+ (R0–RB)(B/S)(1 –Tc)
	13.14% =R0+ (R0 - 6.3%)(0.8)(1 - 0.25)
	13.14% =R0+ R0 x 0.6 - 3.78%
	R0 = (13.14% + 3.78%)/(1.60)
	R0 = 16.92%/1.60
	R0 = 10.575 %
	R0 = 10.58 %
C-1.	Cost of equity
:
	cost of equity be if the debt−equity ratio were 2
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS is cost of equity capital    ??
	R0 is cost of equity capital of unlevered firm =10.575%
	RB is Cost of Borrowing = 6.3%
	B/S= Debt equity ratio = 2
	Tc = tax rate = 25%
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS= 10.575%+ (10.575% - 6.3%)(2)(1 – .25)
	RS= 10.575% + 6.4125%
	RS= 16.99%
C-2.
	Cost of equity be if the debt−equity ratio were 1
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS is cost of equity capital    ??
	R0 is cost of equity capital of unlevered firm =10.575%
	RB is Cost of Borrowing = 6.3%
	B/S= Debt equity ratio = 1
	Tc = tax rate = 25%
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS= 10.575%+ (10.575% - 6.3%)(1)(1 – .25)
	RS= 10.575% + 3.20625%
	RS= 13.78125%
	RS= 13.78%
C-3.
	cost of equity be if the debt−equity ratio were zero
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS is cost of equity capital    ??
	R0 is cost of equity capital of unlevered firm =10.575%
	RB is Cost of Borrowing = 6.3%
	B/S= Debt equity ratio = 0
	Tc = tax rate = 25%
	RS=R0+ (R0–RB)(B/S)(1 –Tc)
	RS= 10.575%+ (10.575% - 6.3%)(0)(1 – .25)
	RS= 10.575% + 0
	RS= 10.575%
	RS= 10.58%