Question

Jungle, Inc., has a target debt—equity ratio of 0.87. Its WACC is 11 percent, and the tax rate is 32 percent.

Required: (a) If Jungle's cost of equity is 15 percent, what is the pretax cost of debt? (Do not round your intermediate calculations.)

(b) If instead you know that the aftertax cost of debt is 7.2 percent, what is the cost of equity? (Do not round your intermediate calculations.)

Answer 1

debt—equity ratio=debt/equity

Hence debt=0.87equity

Let equity be $x

Hence debt=$0.87x

Total=$1.87x

1.WACC=Respective costs*Respective weights

11=(x/1.87x*15)+(0.87x/1.87x*Cost of debt)

(11-8.021390374)=(0.87/1.87*Cost of debt)

Cost of debt=(2.978609626*1.87/0.87)

=6.402%(Approx)

Hence pretax cost of debt=6.402/(1-tax rate)

=6.402/(1-0.32)

=9.42%(Approx).

2.

11=(0.87x/1.87x*7.2)+(x/1.87x*Cost of equity)

Cost of equity=(11-3.34973262)*1.87

which is equal to

=14.306%