Question

Dickson, Inc., has a debt-equity ratio of 2.75. The firm’s weighted average cost of capital is 12 percent and its pretax cost of debt is 8 percent. The tax rate is 22 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. What would the company’s weighted average cost of capital be if the company's debt-equity ratio were .35 and 1.75? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

D/A = D/(E+D)

D/A = 2.75/(1+2.75)

=0.7333

E/A = 1-D/A

=1-0.7333

=0.2667

a

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

0.12= Levered cost of equity*0.2667+0.08*(1-0.22)*0.7333

Levered cost of equity =27.84%

b

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

0.278373003374578 = Unlevered cost of equity+2.75*(Unlevered cost of equity-0.08)*(1-0.22)

Unlevered cost of equity = 14.31

C

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

Levered cost of equity = 14.31+0.35*(14.31-0.08)*(1-0.22)

Levered cost of equity = 18.19

D/A = D/(E+D)

D/A = 0.35/(1+0.35)

=0.2593

Weight of equity = 1-D/A

Weight of equity = 1-0.2593

W(E)=0.7407

Weight of debt = D/A

Weight of debt = 0.2593

W(D)=0.2593

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

After tax cost of debt = 8*(1-0.22)

= 6.24

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

WACC=6.24*0.2593+18.19*0.7407

WACC =15.09%

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

Levered cost of equity = 14.31+1.75*(14.31-0.08)*(1-0.22)

Levered cost of equity = 33.73

D/A = D/(E+D)

D/A = 1.75/(1+1.75)

=0.6364

Weight of equity = 1-D/A

Weight of equity = 1-0.6364

W(E)=0.3636

Weight of debt = D/A

Weight of debt = 0.6364

W(D)=0.6364

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

After tax cost of debt = 8*(1-0.22)

= 6.24

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

WACC=6.24*0.6364+33.73*0.3636

WACC =16.24%