Question

Fyre, Inc., has a target debt?equity ratio of 1.50. Its WACC is 8 percent, and the tax rate is 35 percent.

A) If the company’s cost of equity is 14 percent, what is its pretax cost of debt?

B) If instead you know that the aftertax cost of debt is 4.1 percent, what is the cost of equity?

Answer 1

Solution:

Debt - Equity ratio=1.50/1

WACC= 8%

Tax Rate(t)=35%

(A) if cost of equity (ke) =14%

Pre tax Cost of debt(kd) =??

WACC= Weight of equity(We)*ke+ Weight of debt(Wd)*Kd(1-t)

0.08=1/2.50*0.14+1.50/2.50*kd(1-0.35)

0.08=0.056+0.6*kd*0.65

0.08-0.056=0.39*kd

0.024=0.39kd

Kd=0.024/0.39=0.0615

Pre tax cost of debt(kd) =6.15%

(B) After tax cost of debt=4.1%

Cost of equity (ke)=??

WACC= We*ke+Wd*after tax cost of debt

0.08=1/2.50*ke+1.50/2.50*0.041

0.08=0.40ke+0.0246

0.08-0.0246=0.40ke

0.0554=0.40ke

Ke=0.0554/0.40

Cost of equity(ke)= 0.1385=13.85%