Question

Tulip, Inc., has a target debt—equity ratio of 1. Its WACC is 8 percent, and the tax rate is 35 percent. If you know that the pre-tax cost of debt is 6.0 percent, what is the cost of equity?

Answer 1

Weighted average cost of capital (WACC) = [(S/S+B)*Rs + (B/S+B)*Rb(1-tc)]
	S = equity, B = debt, Rs = Cost of equity, Rb = cost of debt,
	tc = corporations tax rate
Rb = .06
tc = .35
B/S = 1
B = S
S/(S+B) = S/2S
S/(S+B) = 1/2
S/(S+B) = .5
B/(S+B) = B/2B
B/(S+B) = 1/2
B/(S+B) = .5
WACC = .08
.08 = .5*Rs + .5*(.06)*(1-.35)
.08 = .5*Rs + .0195
.5*Rs = (.08 - .0195)
.5Rs = .0605
Rs = .121.
The cost of equity is 12.1%.