Question

Weston Industries has a debt-equity ratio of 1.6. Its WACC is 12 percent, and its cost of debt is 10 percent. The corporate tax rate is 35 percent. (Do not include the percent signs (%). Round your answers to 2 decimal places. (e.g., 32.16))

Required:

a.	Weston’s cost of equity capital is  percent.

b.	Weston’s unlevered cost of equity capital is  percent.

c.	The cost of equity would be  percent if the debt-equity ratio were 2,  percent if the debt-equity ratio were 1, and  percent if the debt-equity ratio were 0.

Answer 1

a). WACC = [wD * kD * (1 - t)] + [wE * kE]

12% = [{1.6 / (1 + 1.6)} * 10% * (1 - 0.35)] + [{1 / (1 + 1.6)} * kE]

12% = 4% + [0.3846 * kE]

0.3846 * kE = 12% - 4%

kE = 8% / 0.3846 = 20.8%

b). kE_L = kE_U + [(kE_U - kD) * (D/E) * (1 - t)]

20.8% = kE_U + [(kE_U - 10%) * 1.6 * (1 - 0.35)]

20.8% = kE_U + [(kE_U - 10%) * 1.04]

20.8% = kE_U + 1.04(kE_U) - 10.4%

2.04(kE_U) = 20.8% + 10.4%

kE_U = 31.2% / 2.04 = 15.29%

c-1). If D-E Ratio = 2;

kE_L = kE_U + [(kE_U - kD) * (D/E) * (1 - t)]

= 15.29% + [(15.29% - 10%) * 2 * (1 - 0.35)]

= 15.29% + 6.88% = 22.18%

c-2). If D-E Ratio = 1;

kE_L = kE_U + [(kE_U - kD) * (D/E) * (1 - t)]

= 15.29% + [(15.29% - 10%) * 1 * (1 - 0.35)]

= 15.29% + 3.44% = 18.74%

c-3). If D-E Ratio = 0;

kE_L = kE_U + [(kE_U - kD) * (D/E) * (1 - t)]

= 15.29% + [(15.29% - 10%) * 0 * (1 - 0.35)]

= 15.29% + 0% = 15.29%