Kose has a target debt to equity ration of .65. Its WACC is 11.2% and tax rate i
ID: 2664469 • Letter: K
Question
Kose has a target debt to equity ration of .65. Its WACC is 11.2% and tax rate is 35%.A)If Kose Cost of equity is 15%, what is its pretax cost of debt?
I attempted by the steps below but the total doesn't not make sense based upon numbers not sure where I went wrong.
=(1/1.65)*(0.15)+(0.65/1.65)*(1-0.35) = 34.7%
B) If instead you know that the aftertax cost of debt is 6.4%, what is the cost of equity? =14.42%
Since the 6.4 is stated in B as the aftertax cost I expected to get something in the rage of 8.2%-8.7%
Please help, it will be grealy appreciated. Thank you!!!
Explanation / Answer
Kose target debt to equity ratio = 0.65
Weighted Average Cost of Capital (WACC) = 11.2%
Tax rate = 35%
(A) If Kose Cost of equity is 15%, what is its pretax cost of debt?
Debt to Equity ratio = 0.65
Total Equity = 1 + 0.65
Total Equity = 1.65
Total Debt = 0.65
Total Equity Weight = 1 / 1.65
Total Debt Weight = 0.65 / 1.65
Total Equity Weight = 0.61
Total Debt Weight = 0.39
Total Market Capital = 0.61 + 0.39 = 1
Target Weight on Equity (E/V) = 0.61
Target Weight on Debt (D/V) = 0.39
Calculating Pre-tax Cost of Debt (RD):
Cost of Equity (RE) = 15%
Weighted Average Cost of Capital (WACC) = 11.2%
Tax Rate (Tc) = 35%
WACC = [(E/V) * RE + (D/V) * RD (1-Tc)]
11.2% = [(0.61 * 0.15) + 0.39 * RD]
0.112 = [0.0915 + 0.39 * RD (1-0.35)]
0.112 – 0.0915 = [0.39 * RD (1-0.35)]
0.0205 = RD * 0.2535
RD * 0.2535 = 0.0205
Cost of Debt (RD) = 0.0205 / 0.2535
Cost of Debt (RD) = 0.08086785 (or) 8.09%
Cost of Debt (RD) = 8.09%
(B) If instead you know that the after tax cost of debt is 6.4%, what is the cost of equity?
WACC = [(E/V) * RE + (D/V) * RD (1-Tc)]
11.2% = [(0.61 * RE) + (0.39 * 0.064]
11.2% = [(0.61 * RE) + (0.39 * 0.064]
11.2% = [(0.61 * RE) + 0.02496
0.112 – 0.02496 = 0.61 * RE
0.08704 = 0.61 * RE
0.61 * RE = 0.08704
Cost of Equity (RE) = 0.08704 / 0.61
Cost of Equity (RE) = 0.14268 (or) 14.24%
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