Question

Starset, Inc., has a target debt-equity ratio of 0.78. Its WACC is 10.5 percent, and the tax rate is 31 percent.

A. If the company's cost of equity is 16 percent, what is the pretax cost of debt?

B. If instead you know that the aftertax cost of debt is 6.6 percent, what is the cost of equity?

Answer 1

debt-equity ratio=debt/equity

Hence debt=0.78 equity

Let equity be $x

Debt=$0.78x

Total=$1.78 x

WACC=Respective costs*Respective weight

1.

10.5=(x/1.78x*16)+(0.78x/1.78x*Cost of debt)

10.5=8.988764045+(0.78/1.78*Cost of debt)

Cost of debt=(10.5-8.988764045)*(1.78/0.78)

=3.448717949%

Hence pretax Cost of debt=Cost of debt/(1-tax rate)

=3.448717949%/(1-0.31)

=5%(Approx).

2.

10.5=(x/1.78x*Cost of equity)+(0.78x/1.78x*6.6)

10.5=(1/1.78*Cost of equity)+2.892134831

Cost of equity=(10.5-2.892134831)*1.78

=13.542%