Question

Problem 9-8
WACC

David Ortiz Motors has a target capital structure of 30% debt and 70% equity. The yield to maturity on the company's outstanding bonds is 8%, and the company's tax rate is 40%. Ortiz's CFO has calculated the company's WACC as 9.32%. What is the company's cost of equity capital? Round your answer to two decimal places.

%?

Answer 1

Calculation of Cost of equity:

Particulars	Probability (1)	Cost (2)	WACC (3) (1*2)
Debt	0.3	4.8% (Note)	1.44%
Equity	0.7	×%	0.7*×%
		WACC	9.32%

Let cost of equity will be ×%

Calculation of cost of common equity:

0.3*4.8%+0.7*×%= 9.32%

1.44%+0.7*×% = 9.32%

0.7*×% = 9.32%-1.44%

0.7*×%= 7.88%

×% = 7.88%/0.7

×% = 11.26%

Cost of common equity (ke) = 11.26%

Note:Calculation of Cost of debt (kd):

After tax cost of debt = Cost of debt - Tax

= 8%-8%*40%

= 8%-3.2%

kd= 4.8%

Company's Cost of common equity (ke) = 11.26%