Question

Starset, Inc., has a target debt-equity ratio of 0.73. Its WACC is 11 percent, and the tax rate is 31 percent.

If the company's cost of equity is 16 percent, what is the pretax cost of debt?

If instead you know that the aftertax cost of debt is 6.5 percent, what is the cost of equity?

Answer 1

Answer a)

Debt Equity Ratio = 0.73

Debt = 0.73

Equity = 1

Total Capital = 1.73

let the cost of Debt be X

WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt)

11% = 16% * 1 / 1.73 + X * (1-0.31)* 0.73 / 1.73

11% = 9.24855491329% + X * 0.29115606936  

X * 0.29115606936 = 11% -  9.24855491329%

X = 11% -  9.24855491329% / 0.29115606936

X = 6.02%

Answer b)

let the cost of Equity be X

WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt after tax * Weight of Debt)

11% = X * 1 / 1.73 + 6.5% * (1-0.31)* 0.73 / 1.73

11% = X * 0.57803468208 + 1.89251445086%  

X = 11% - 1.89251445086% / 0.57803468208

X = 15.76%