Question

Crowley Company has a capital structure with 35% debt at a 9% interest rate.  Its beta is 1.3, the risk-free rate is 1.5%, and the market risk premium is 10%. The company has no preferred stock.   Its combined federal-plus-state tax rate is 25%.

a. Calculate the company's cost of equity

b. Calculate the company's weighted average cost of capital

c. Calculate the company's unlevered cost of equity

Answer 1

(a)

Compute the cost of equity (Ke), using the equation as shown below:

Ke = Risk-free rate + {Beta*Market premium}

      = 1.5% + {1.3*10%}

      = 14.5%

Hence, the Ke is 14.5%.

(b)

Compute the cost of debt (Kd), using the equation as shown below:

Kd = Interest*(1 – Tax rate)

      = 9%*(1 – 0.25)

      = 6.75%

Hence, the Kd is 6.75%.

Compute the weighted average cost of capital (WACC), using the equation as shown below:

WACC = (Equity weight*Ke) + (Debt weight*Kd)

             = (65%*14.5%) + (35%*6.75%)

             = 9.425% + 2.3625%

             = 11.7875

Hence, the WACC is 11.7875.

(c)

Compute the unlevered beta, using the equation as shown below:

Unlevered beta = Levered beta/ [1 + {(Debt/ Equity)*(1 – Tax rate)}]

                         = 1.3/ [1 + {(35%/ 65%)*(1 – 0.25)}]

                         = 1.3/ [1 + 0.40384615385]

                         = 0.92602739725

Hence, the unlevered beta is 0.92602739725.

Compute the unlevered cost of equity (Ke), using the equation as shown below:

Unlevered Ke = Risk-free rate + {Unlevered beta*Market premium}

                       = 1.5% + {0.92602739725*10%}

                       = 10.7602739725%

Hence, the unlevered Ke is 10.7602739725%.