Question

Starset, Inc., has a target debt-equity ratio of 0.71. Its WACC is 10.5 percent, and the tax rate is 35 percent.

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

If instead you know that the aftertax cost of debt is 6.9 percent, what is the cost of equity?

Answer 1

Debt-equity ratio=debt/equity

Hence debt=0.71 equity

Let equity be $x

Debt=0.71 x

Total=$1.71 x

WACC=Respective costs*Respective weight

a.

10.5=(x/1.71x*16)+(0.71x/1.71x*Cost of debt)

10.5=9.356725146+(0.71/1.71*Cost of debt)

Cost of debt=(10.5-9.356725146)*(1.71/0.71)

=2.753521127%

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

=2.753521127/(1-0.35)

=4.24%(Approx).

b.

10.5=(x/1.71x*Cost of equity)+(0.71x/1.71x*6.9)

10.5=(1/1.71*Cost of equity)+2.864912281

Cost of equity=(10.5-2.864912281)*1.71

=13.056%