Question

Starset, Inc., has a target debt-equity ratio of 0.76. Its WACC is 11 percent, and the tax rate is 34 percent.

A. If the company's cost of equity is 15.5 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=0.76 equity

Let equity be $x

Hence debt=$0.76x

Total=$1.76x

WACC=Respective costs*Respective weight

1.

11=(x/1.76x*15.5)+(0.76x/1.76x*Cost of debt)

11=8.806818182+(0.76/1.76*Cost of debt)

Cost of debt=(11-8.806818182)*1.76/0.76

=5.08%(Approx)

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

=5.08/(1-0.34)

=7.70%(Approx)

b.

11=(0.76x/1.76x*6.6)+(x/1.76x*Cost of equity)

11=2.85+(1/1.76*Cost of equity)

Cost of equity=(11-2.85)*1.76

=14.344%