Question

De Leon Imports is currently 100% equity financed, but would like to have a debt to equity ratio of 0.8. If their cost of equity is currently 10.2%, what will it be after the move? Their cost of debt is 4.1% and their tax rate is 31%.

Answer 1

Current Cost of Equity = 10.2%

Since, currently Equity is financed 100% of capital structure, which means cost of Equity is Cost of Capital(WACC).

Now, it wants to change its capital structure to Debt to Equity ratio of 0.8

So, Debt is 0.8 & Equity is 1

Total Capital Structure = 0.8 + 1 = 1.8

Cost of Debt = 4.1%

Cost of Capital (WACC) will be same = 10.2%

Calculating the new cost of Equity using WACC formula:-

WACC= (Weight of Debt)(Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

10.2% = (0.8/1.8)(4.1%)(1-0.31) + (1/1.8)(Cost of Equity)

10.2% = 1.2573% + 0.5555(Cost of Equity)

Cost of Equity = 16.10%

SO, new cost of Equity is 16.10%