Question

Prokter and Gramble (PG) has historically maintained a debt-to-equity ratio (D/E) of approximately 0.4. Its return on equity is 7.5% and it can borrow at 4.3%. PG’s tax rate is 40%. PG believes it can increase debt without any serious risk of distress or other costs. With a higher debt-to-equity ratio of 0.6, it believes its borrowing costs will rise only slightly to 4.6%.

a. Determine PG’s current asset return rA (before increasing its debt-to-equity ratio)

b. Determine PG’s cost of capital after PG raises its debt-to-equity ratio to 0.6.

Answer 1

(a): Here D/E = 0.4 and this means that debt is 40% of equity. Thus if debt is 40 then equity is 100 and so total assets is 100+40 = 140. ROE = 7.5%

We know that ROA = net income/assets and ROE = net income/equity. Thus ROA = ROE * equity/assets. Thus ROA = 7.5% * 100/140 = 5.36%

Thus PG’s current asset return rA is 5.36%

(b): We know that WACC = Ke * ( E/A) + Kd after tax * ( D/A)

Thus when D/E is raised to 0.6 then assets will become 60+100 = 160

So WACC = 7.5%*100/160 + 4.6%*(1-40%)*60/160

= 4.6875% + 1.035%

= 5.72%