Question

Abbe Technology (AT) has no debt and its assets cost of capital is 10%. The capital market is perfect.

If AT borrowed to reach a debt-to-equity ratio of 1.5, the cost of equity would be 13.75%. What would AT's cost of debt be after this (hypothetical) increase in leverage?

If AT borrowed to reach a debt-to-equity ratio of 0.5, the cost of debt would be 7%. What would AT's cost of equity be after this (hypothetical) increase in leverage?

Answer 1

Sol:

Unlevered cost of equity	10%
Particulars	Case 1	Case 2
Debt equity ratio	1.5	0.5
Cost of debt	7.50%	7%
Leveraged cost of equity	13.75%	11.50%

Formula used are

Cost of levered equity = Cost of unlevered equity + D/E ratio*(1-tax)*(Cost of unlevered equity - Cost of debt)

Cost of debt = Cost of unlevered equity - [(Cost of levered equity - Cost of unlevered equity)/(D/E ratio x (1-Tax)]

Note - Since tax rate is not given, tax is ignored.

Therefore AT cost of equity is 11.50% and cost of debt is 7.50%