Question

A company's CFO wants to maintain a target debt-to-equity ratio of 1/3. If the WACC is 18.6%, and the pretax cost of debt is 9.4%, what is the cost of common equity assuming a tax rate of 33%??

Answer 1

Answer:

Debt-Equity Ratio = 1/3

Weight of Debt = 1/4
Weight of Debt = 0.25

Weight of Equity = 3/4
Weight of Equity = 0.75

Pre-tax cost of debt = 9.4%
After-Tax Cost of Debt = 9.4% * (1 – 0.33)
After-Tax Cost of Debt = 6.298%

WACC = (Weight of Debt * After-Tax Cost of Debt) + (Weight of Equity * Cost of Equity)
18.6% = (0.25 * 6.298%) + (0.75 * Cost of Equity)
18.6% = 1.5745% + (0.75 * Cost of Equity)
17.0255% = (0.75 * Cost of Equity)
Cost of Equity = 22.70%