Skillet Industries has a debt–equity ratio of 1.3. Its WACC is 8.6 percent, and

Question

Skillet Industries has a debt–equity ratio of 1.3. Its WACC is 8.6 percent, and its cost of debt is 7.4 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

Debt Equity ratio = 1.3

Weight of debt = 52.52%

Weight of equity = 47.48%

Cost of debt = 7.4%

Tax rate = 35%

After tax cost of debt = 7.4% × (1 – 35%)

                                   = 4.81%

After tax cost of debt is 4.81%.

a.

WACC = 8.6%

Cost of equity is calculated below:

WACC = 52.52% × 4.81% + 47.48% × Cost of equity

8.60% = 2.53% + 47.48% × Cost of equity

Cost Of equity = 12.79%

Cost of equity is 12.79%.

b.

Unlevered firm mean value of debt is Zero.

Unlevered cost of equity is calculated below using following formula:

WACC = (D / D + E) × after tax cost of debt + (E / D + E) × cost of equity

8.6% = 0 + (E / 0 + E) × cost of equity

Cost of equity = 8.6%

Unlevered cost of equity is 8.60%.

c.

Debt equity ratio = 2

Value of debt = 2

Value of equity = 1

Cost of equity if debt equity ratio is 2 is calculated below using following formula:

WACC = (D / D + E) × after tax cost of debt + (E / D + E) × cost of equity

8.6% = (2 / 3) × 4.81 + (1 / 2 + 1) × cost of equity

8.6% - 3.21% = (1 / 3) × cost of equity

Cost of equity = 16.18%

Cost of equity if debt equity ratio of 2 is 16.18%.

d.

Debt equity ratio = 1

Value of debt = 1

Value of equity = 1

Cost of equity if debt equity ratio is 2 is calculated below using following formula:

WACC = (D / D + E) × after tax cost of debt + (E / D + E) × cost of equity

8.6% = (1 / 2) × 4.81 + (1 / 2) × cost of equity

8.6% - 2.4% = (1 / 2) × cost of equity

Cost of equity = 12.4%

Cost of equity if debt equity ratio of 1 is 12.40%.

e.

Debt equity ratio = 0

Value of debt = 0

Value of equity = 1

Cost of equity if debt equity ratio is 2 is calculated below using following formula:

WACC = (D / D + E) × after tax cost of debt + (E / D + E) × cost of equity

8.6% = (0) × 4.81 + (1 / 0 + 1) × cost of equity

8.6% = (1 /) × cost of equity

Cost of equity = 8.60%

Cost of equity if debt equity ratio of 0 is 8.60%.

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