Question

Starset, Inc., has a target debt-equity ratio of 0.87. Its WACC is 10 percent, and the tax rate is 34 percent.

     

If the company's cost of equity is 15.5 percent, what is the pretax cost of debt?

• 5.57%
• 13.91%
• 7.9%
• 6.24%
• 5.31%

If instead you know that the aftertax cost of debt is 6.9 percent, what is the cost of equity?

• 12.7%
• 30.75%
• 13.56%
• 13.21%
• 12.19%

Answer 1

Ans:- (a) WACC is given by (E / E + D) * cost of equity (ke) + (D / E + D) * cost of debt (kd) * (1 - Tax rate), where E is the equity and D is the debt.

WACC is given 10% i.e 0.10, ke = 0.155, tax rate = 0.34

Debt-equity ratio = 0.87 / 1 that means Debt is 0.87 and Equity is 1 and E+D will be 0.87 + 1 = 1.87

Now 0.10 = ( 1/ 1.87 ) * 0.155 + ( 0.87 / 1.87) * kd * (1 - 0.34)

0.10 = 0.0829 + 0.3071 * kd

or kd = ( 0.10 - 0.8289 ) / 0.3071 = 0.0557 = 5.57%. option (a) is the right answer.

(b) If after-tax cost of debt is 6.9%, then

0.10 = (1 /1.87) * ke + ( 0.87 / 1.87) * 0.069

0.10 = 0.5348 * ke + 0.0321

or ke = ( 0.10 - 0.0321 ) / 0.5348 = 0.1270 = 12.70%. option (a) is the right answer.

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