Weston Industries has a debt–equity ratio of 1.4. Its WACC is 8.0 percent, and i

Question

Weston Industries has a debt–equity ratio of 1.4. Its WACC is 8.0 percent, and its cost of debt is 5.9 percent. The corporate tax rate is 35 percent.

  

What is Weston’s cost of equity capital? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

What is Weston’s unlevered cost of equity capital? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

  

What would the cost of equity be if the debt–equity ratio were 2? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

  

What would the cost of equity be if the debt–equity ratio were 1.0? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

  

What would the cost of equity be if the debt–equity ratio were zero? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Weston Industries has a debt–equity ratio of 1.4. Its WACC is 8.0 percent, and its cost of debt is 5.9 percent. The corporate tax rate is 35 percent.

Explanation / Answer

Solution.

A. What is Weston’s cost of equity capital.

If D/E = 1.4,

Then Debt to capital = D/E / (1+ D/E) = 1.4/2.4 = 0.58

This is the weight of debt in WACC
Recall the formula for WACC, WACC = We(Re) + Wd(Rd * (1 - t)),

Where,

W=weight, R=rate, t=tax rate in decimal form
We = (1 - Wd), so... We = (1 - 0.58) = 0.42
next, substitute your values into the equation...
0.08 = 0.42Re + 0.58 (0.059 * 0.65)
0.08 = 0.42Re + 0.0222
0.0578 = 0.42Re
Re = 0.137619

B. Incomplete informetion for this calculation.

C1. What would the cost of equity be if the debt–equity ratio were 2.

If D/E = 2.00,

Then Debt to capital = D/E / (1+ D/E) = 2.00 / 3.00= 0.67

= (1 - Wd), so... We = (1 - 0.67) = 0.33

Next, substitute values into the equation...
0.08 = 0.33Re + 0.67 (0.059 * 0.65)
0.08 = 0.33Re + 0.0256
0.0544 = 0.33Re
Re = 0.1648 or 16.48%

C2. What would the cost of equity be if the debt–equity ratio were 1.0.

If D/E = 1.00,

Then Debt to capital = D/E / (1+ D/E) = 1.00 / 2.00= 0.50

= (1 - Wd), so... We = (1 - 0.50) = 0.50

Next, substitute values into the equation...
0.08 = 0.5Re + 0.50 (0.059 * 0.65)
0.08 = 0.50Re + 0.01917
0.0.06083 = 0.50Re
Re = 0.1216 or 12.16%

C3. What would the cost of equity be if the debt–equity ratio were zero.

D/E = 0, (and no preferred stock)

WACC = re,

So re = 12% when D = 0

0 1 2 3 = 2 x 3 Capital Weight Cost WACC Debt                 0.42 0.137619      0.0578 Equity                 0.58 0.03835      0.0222 WACC                 1.00      0.0800

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