Question

Dickson, Inc., has a debt-equity ratio of 2.05. The firm’s weighted average cost of capital is 11 percent and its pretax cost of debt is 8 percent. The 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.	What would the company’s weighted average cost of capital be if the company's debt-equity ratio were .55 and 1.05? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

a. The cost of capital for the company is :

D/E = 2.05, LET E= 1

D/A = 2.05/3.05

E/A = 1/3.05

SO, WACC IS :

0.11 =2.05/3.05* 0.08* (1 - TAX RATE ) + 1/3.05* Re

or, 0.11 = 0.036 + 0.3443*Re

Re = 21.49%

b. The unlevered cost of equity is :

According to the Modiglani-Miller , a firms unlevered cost of equity,

Re = Ro + (Ro - Rd) D/E * (1- TAX RATE)

Or, 0.2149 = Ro + (Ro - 0.08) * 2.05 *0.77

0.2149 = Ro +  1.5785Ro - 0.1263

0.2149 + 0.1263 = R0 *2.5785

Ro = 13.23%

c. Calculating the new Re, given the D/E = 0.55

Re = Ro + (Ro - Rd) *D/E (1 - tax rate)

= 13.23 + ( 13.23 - 0.08)*0.55 *0.77

=18.79%

SO, the WACC is :

=0.55/1.55 * 0.08* 0.77 + 1/1.55 * 0.1879

= 0.0215 + 0.1212

=14.27%

Re = Ro + (Ro - Rd) * D/E * (1 - TAX RATE)

OR, = 13.23 + (13.23 - 0.08)*1.05* 0.77

=23.86%

WACC is :

= 1.05/2.05 * 0.08*0.77 + 1/2.05 * 0.2386

=0.0316 + 0.1164

=14.799%

=14.8% (rounded off to two decimal places)