Question

3. Maxwell Industries has a debt– equity ratio of 1.5. Its WACC is 11 percent, and its cost of debt is 8 percent. The corporate tax rate is 35 percent. a. What is Maxwell’s cost of equity capital? b. What is Maxwell’s unlevered cost of equity capital?

Answer 1

1) Calculation of Cost of equity = Let 'x'

Cost of debt = 8% (1 - tax rate)

cost of debt = 8%(1-35%) = 8%(65%) = 5.2%

WACC = 11%

Debt equity ratio = 1.5 where weight of debt is 1.5/2.5 = 60% and weight of equity is 1/2.5 = 40%

Now, WACC = weight of equity*cost of equity + Weight of debt*cost of debt

WACC = 40%*x + 60%*5.2%

11% = 40%x + 3.12

40%x = 7.88

x = 19.7%

2) Maxwell Unlevered cost of equity capital

Equity cost of capital = Re = 19.7%

Unlevered cost of equity capital = Ru = let 'x'

Cost of debt = Rd = 8%

Re = Ru + (Ru - Rd)(D/E)(1 - tax)

19.7% = x + (x - 8%)(1.5)(1-35%)

19.7% = x + (x - 8%)(0.975)

19.7% = x + 0.975x - 7.8%

1.975x = 27.5%

x = 13.92%