Question

WB Industries has a debt-equity ratio of .8. Its WACC is 9.2 percent, and its cost of debt is 4.9 percent. The corporate tax rate is 35 percent.

What would the cost of equity be if the debt-equity ratio were .95?

12.84%

15.83%

14.58%

22.59%

23.45%

Answer 1

it is given debt equity ratio = 0.8

so weight of equity(We) = 1/(1+0.80) = 0.556

weight of debt(Wd) = 0.8 / (1+0.8) = 0.444

WACC = (We * cost of equity) + (Wd* Kd *(1-tax)) (Kd = cost of debt)

9.2 = (0.556*Ke) + (0.444*4.9*(1-0.35))

cost of equity(Ke) = 14.01%

now we have to find out unlevered cost of equity capital(K(ue))

Ke = K(ue) + (K(ue) - Kd)*debt equity ratio * (1 - tax)

14.01 = K(ue) + (K(ue) - 4.9)*0.8*(1-0.35)

cost of unlevered equity capital (K(ue)) = 10.89%

now when D/E ratio = 0.95 cost of equity willbe as follows:

Ke = K(ue) + (K(ue) - Kd)*debt - equity ratio * (1 - tax)

Ke = 10.89% + (10.89% - 4.9%)*0.95*(1-0.35)

Ke = 14.58%

so cost of equity when debt equity ratio 0.95 is 14.58%

third option is correct