Question

De Leon Imports is currently 100% equity financed, but would like to have a debt to equity ratio of 0.9. If their cost of equity is currently 12.7%, what will it be after the move? Their cost of debt is 6.3% and their tax rate is 21%.

Please give your answer in the form of a decimal, to the nearest 0.001. For example, if the cost of equity is 8.67%, your answer should be 0.087.

Answer 1

Cost of Equity (Weighted Average Cost of Equity - WACC):

WACC = (Cost of Equity * Weight of Equity) + (After Tax Cost of Debt * Weight of Debt)

Cost of Equity = 12.7%

Weight of Equity = Weight of Equity / (Weight of Equity + Weight of Debt)

Debt Equity Ratio = 0.9

This means, for every $0.90 of debt, the company has $1 equity

Hence,

Weight of Equity = 1 / (1 + 0.90)

= 1 / (1.90)

= 0.526

Cost of Debt = 6.3%

After Tax Cost of Debt = Cost of Debt * (1 - tax rate)

= 6.3% * (1 - 0.21)

= 6.3% * 0.79

= 0.05 * 100

= 5%

Weight of Debt = Weight of Debt / (Weight of Equity + Weight of Debt)

= 0.90 / 1.90

= 0.474

WACC = (12.7% * 0.526) + (5% * 0.474)

= 6.680 + 2.37

= 9.05% = 0.0905

Cost of Equity = 0.091 (rounded off)