Question

Paget, Inc., has a target debt−equity ratio of 1.65. Its WACC is 9.1 percent, and the tax rate is 40 percent.

a.	If the company’s cost of equity is 12 percent, what is its pretax cost of debt? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Cost of debt

%

b.	If instead you know that the aftertax cost of debt is 6.8 percent, what is the cost of equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Cost of equity

%

Answer 1

Debt-equity ratio=debt/equity

Hence debt=1.65*equity

Let equity be $x

Debt=1.65x

Total=2.65x

WACC=Respective cost*Respective weight

a.9.1=(x/2.65x*12)+(1.65x/2.65x*Cost of debt)

9.1=4.52830189+(1.65/2.65*Cost of debt)

Cost of debt =(9.1-4.52830189)*2.65/1.65

=7.34242424%

Pre-tax cost of debt=Cost of debt/(1-tax rate)

=7.34242424/(1-0.4)

=12.24%(Approx).

b.9.1=(x/2.65x*Cost of equity)+(1.65x/2.65x*6.8)

9.1=(1/2.65*Cost of equity)+4.23396226

Cost of equity=(9.1-4.23396226)*2.65

=12.9%(Approx).