Question

Kose, Inc. has a target debt-equity ratio of 0.38. Its WACC is 10.1% and the tax rate is 25%.

            a. If the company’s cost of equity is 12%, what is the pretax cost of debt?

            b. If instead you know the aftertax cost of debt is 6.4%, what is the cost of equity?

Answer 1

D/A = D/(E+D)

D/A = 0.38/(1+0.38)

=0.2754

Weight of equity = 1-D/A

Weight of equity = 1-0.2754

W(E)=0.7246

Weight of Equity = 0.7264

Weight of Debt = 0.2754

Cost of Capital = Weight of Equity*Cost of Equity+Weight of Debt*Cost of Debt

10.1 = 12*0.7264+Cost of Debt*0.2754

Cost of Debt = 5.0225 = after tax rate

After tax rate = YTM * (1-Tax rate)

5.0225 = YTM * (1-0.25)

YTM = 6.7 = pre tax rate

a

Weight of Equity = 0.7264

Weight of Debt = 0.2754

Cost of Capital = Weight of Equity*Cost of Equity+Weight of Debt*Cost of Debt

10.1 = Cost of Equity*0.7264+6.4*0.2754

Cost of Equity = 11.4778

b