Question

David Ortiz Motors has a target capital structure of 40% debt and 60% equity. The yield to maturity on the company's outstanding bonds is 9%, and the company's tax rate is 25%.

Ortiz's CFO has calculated the company's WACC as 9.9%. What is the company's cost of equity capital?

Answer #1

**Answer :**

**First, we need to calculate the after tax cost of
debt:**

Yield to maturity on the bond is the Before tax cost of debt.

After tax cost of debt = Before tax cost of debt * ( 1 - tax rate )

= 9% * ( 1 - 0.25 ) = 6.75%

**Now, Calculation of Cost of equity as
follows:**

WACC = ( Weight of debt * After tax cost of debt ) + ( Weight of equity * Cost of equity )

9.9% = ( 40% * 6.75% ) + ( 60% * Cost of equity )

9.9% = 2.70% + ( 60% * Cost of equity )

7.20% = 60% * Cost of equity

**Cost of equity = 12%**

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WACC
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and 65% equity. The yield to maturity on the company's outstanding
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Problem 9-8
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