Question

Weston Industries has a debt-equity ratio of 1.3. Its WACC is 8.5 percent, and its cost of debt is 6.2 percent. The corporate tax rate is 22 percent.

a. What is the company’s cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

b. What is the company’s unlevered cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

c-1. What would the cost of equity be if the debt-equity ratio were 2? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

c-2. What would the cost of equity be if the debt-equity ratio were 1.0? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

c-3. What would the cost of equity be if the debt-equity ratio were zero? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer #1

RWACC = (E/V)*RE + (D/V)*RD*(1-Tc) = 8.5%

where RWACC is weighted average cost of capital

E= portion of equity

D= portion of debt

V= E+D

Since, D/E =1.3

So, D= 1.3 E or V= 2.3 E

RE is cost of equity

RD is cost of debt = 6.2%

Tc is the tax rate = 22%

**(a)** Solving the equation,

RWACC = (E/V)*RE + (D/V)*RD*(1-Tc)

8.5% = RE/2.3 + (1.3/2.3)*6.2%*(1-0.22)

**RE = 13.26%**

**(b)** the formula is given as

RE = RU + D/E * (RU - RD)

13.26 = RU + 1.3 (RU - 6.2)

**RU = 9.27%**

**(c1)** when D/E = 2

V= 3 E

RWACC = (E/V)*RE + (D/V)*RD*(1-Tc)

8.5% = RE/3 + (2/3)*6.2%*(1-0.22)

**RE = 15.83%**

**(c2)** when D/E= 1

V= 2 E

RWACC = (E/V)*RE + (D/V)*RD*(1-Tc)

8.5% = RE/2 + (1/2)*6.2%*(1-0.22)

**RE = 14.58%**

**(c3)** when D/E = 0 so, D=0, V=E

RWACC = (E/V)*RE + (D/V)*RD*(1-Tc)

RWACC = 1*RE + 0

**RE = RWACC = 8.5%**

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