Skillet Industries has a debt–equity ratio of 1.8. Its WACC is 9.1 percent, and

Question

Skillet Industries has a debt–equity ratio of 1.8. Its WACC is 9.1 percent, and its cost of debt is 7.1 percent. The corporate tax rate is 35 percent.

a. What is the company’s cost of equity capital? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity capital_________ %

b. What is the company’s unlevered cost of equity capital? (Round your answer to 2 decimal places. (e.g., 32.16))

Unlevered cost of equity capital_________ %

c-1 What would the cost of equity be if the debt–equity ratio were 2? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity_________ %

c-2 What would the cost of equity be if the debt–equity ratio were 1.0? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity_________ %

c-3 What would the cost of equity be if the debt–equity ratio were zero? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity_______ %

Explanation / Answer

The equation for WACC is:

         WACC = (E/V)RE + (D/V)RD(1 – tC)

Where

WACC=9.1%

RD=7.1%

tC=35%

The company has a debt-equity ratio of 1.8, which implies the weight of debt is 1.8/2.8, and the weight of equity is 1/2.8, so

         WACC = .091 = (1/2.8)RE + (1.8/2.8)(.071)(1 – .35)

         0.3571RE = .091-0.0297

        0.3571RE = 0.0613

        RE = .1717 or 17.17%

b.    To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so:

         RE = RU + (RU – RD)(D/E)(1 – tC)

         .1717 = RU + (RU – .071)(1.8)(1 – .35)

         0.1717= RU+1.17 RU-0.08301

        0.25477=2.17 RU

         RU=0.1174=11.74%

c.    To find the cost of equity under different capital structures, we can again use the WACC equation. With a debt-equity ratio of 2, the cost of equity is:

         .091 = (1/3)RE + (2/3)(.071)(1 – .35)   

         0.3333RE = .091-0.0308

        0.3333RE = 0.0602

        RE = .1806 or 18.06%

         With a debt-equity ratio of 1.0, the cost of equity is:

         .091 = (1/2)RE + (1/2)(.071)(1 – .35)     

         0.5RE = .091-0.023075

        0.5RE = 0.0679

        RE = .1359 or 13.59%

         And with a debt-equity ratio of 0, the cost of equity is:

         .091 = (1)RE + (0)(.071)(1 – .35)      

         RE = WACC = .091 or 9.1%

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