Skillet Industries has a debt–equity ratio of 1.4. Its WACC is 9.4 percent, and

Question

Skillet Industries has a debt–equity ratio of 1.4. Its WACC is 9.4 percent, and its cost of debt is 6.7 percent. The corporate tax rate is 35 percent.

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

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

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))

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))

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))

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

Explanation / Answer

Answer a

WACC => (E/V)RE + (D/V)RD(1 – tC)

The company has a debt-equity ratio of 1.4, which implies the weight of debt is 1.4/2.4, and the weight of equity is 1/2.4, so

0.094 => (1/2.4)RE + (1.4 /2.4)(6.7% - 35%)

Company’s cost of equity capital => 0.1646 or 16.46%

Answer 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)

0.1646=> RU + (RU - 0.67) ( 1.4) (1-35%)

Unlevered cost of equity => 0.3871 or 38.71%

Answer c -1

Again we require to use wacc eqaution

If debt equity ratio is 2

0.094 => (1/3)RE + (2 /3) (6.7% - 35%)

Cost of Equity => 0.1949 or 19.49%

Answer c-2

If debt equity ratio is 1

0.094 => (1/2)RE + (1 /2) (6.7% - 35%)

Cost of Equity => 0.1445 or 14.45%

Answer c-3

If debt equity ratio is 0, then cost of equity is equal to WACC

so Cost of Equity => 9.4%

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