Question

Company B has a target debt-equity ratio of .62. Its WACC is 11.3 percent and the tax rate is 21 percent. What is the cost of equity if the after tax cost of debt is 6.3 percent?

Answer 1

Debt/ Equity = 0.62

If Debt, D = 0.62X; Equity, E = X

D/ (D + E) = 0.62 X/ (0.62 X + X) = 0.62 X/1.62 X = 0.62/1.62

E/ (D + E) = X/ (0.62 X + X) = X/1.62 X = 1/1.62

WACC = [E/(D+E) x Re] + [D/ (D+E) x Rd x (1- Tc)]

Re = Cost of equity

Rd = cost of debt

Tc = Tax rate

0.113 = (1/1.62 x Re) + [(0.62/1.62) x 0.063]

       = (Re/1.62) + (0.62 x 0.063)/1.62

Re/1.62 = 0.113 - (0.62 x 0.063)/1.62

Re/1.62 = 0.113 - 0.03906/1.62

Multiplying the equation with 1.62, we get:

Re = 0.113 x 1.62 - 0.03906

= 0.18306 - 0.03906 = 0.14400 or 14.4 %

Cost of equity is 14.4 %