Question

Welling Inc. has a target debt–equity ratio of 0.78. Its WACC is 9.7%, and the tax rate is 35%.

a. If the company’s cost of equity is 14%, what is its pre-tax cost of debt? (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

Cost of debt             %

b. If instead you know that the after-tax cost of debt is 6.8%, what is the cost of equity? (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

Cost of equity             %

Answer 1

Debt-equity ratio=debt/equity

Hence debt=0.78*equity

Let equity be $x

Debt=$0.78x

Total=$1.78x

WACC=Respective cost*Respective weight

a.9.7=(x/1.78x*14)+(0.78x/1.78x*Cost of debt)

9.7=7.86516854+(0.78x/1.78x*Cost of debt)

Cost of debt=(9.7-7.86516854)*1.78/0.78

=4.18717949%(Approx)

Pre-tax cost of debt=Cost of debt/(1-tax rate)

=4.18717949/(1-0.35)

=6.44%(Approx)

b.9.7=(x/1.78x*Cost of equity)+(0.78x/1.78x*6.8)

9.7=(x/1.78x*Cost of equity)+2.97977528

Cost of equity =(9.7-2.97977528)*1.78

=11.96%(Approx)