Question

Welling Inc. has a target debt–equity ratio of 0.77. Its WACC is 9.6%, and the tax rate is 35%.

a. If the company’s cost of equity is 14%, what is its pre-tax cost of debt? (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

Cost of debt             %

b. If instead you know that the after-tax cost of debt is 6.8%, what is the cost of equity? (Do not round intermediate calculations. Round the final answer to 2 decimal places.)

Cost of equity             %

Answer 1

A.

Step 1 - Concept and formulae

WACC = (Wd * Kd) + (We * Ke)

where

Wd = Weight of debt

Kd = Cost of debt = pretax cost of debt * (1-t)

We = Weight of equity

Ke = Cost of equity = 14% (Given)

Step 2 - Calculation of Wd and We

Debt / Equity = 0.77 (given)

If we assume equity = 1

then debt = 0.77

therefore capital employed = debt + equity = 0.77 + 1 = 1.77

Wd = Debt / Capital Employed = 0.77 / 1.77 = 0.4350

We = Equity / Capital Employed = 1/1.77 = 0.5650

Step 3 = caluclation of pre tax cost of debt

WACC = (Wd * Kd) + (We * Ke)

9.6 = 0.4350 * Kd + 0.565 * 14

9.6 = 0.4350 * Kd + 7.90

Kd = 1.69 / 0.435 = 3.8857

pretax cost of debt = 3.8857 / (1-t) = 3.8857 / 0.65 = 5.978

B - Calculation of ke is Kd is 6.8

WACC = (Wd * Kd) + (We * Ke)

9.6 = (0.4350 * 6.8) + 0.565 * Ke

9.6 = 2.9581 + 0.565 * Ke

Ke = 6.6418 / 0.565

Ke = 11.75

Therefore cost of equity = 11.75%