Skillet Industries has a debt–equity ratio of 1.3. Its WACC is 7.1 percent, and

Question

Skillet Industries has a debt–equity ratio of 1.3. Its WACC is 7.1 percent, and its cost of debt is 6.6 percent. The corporate tax rate is 35 percent.

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

B-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))

B-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))

B-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))

Explanation / Answer

A. Unlevered cost of equity capital

D/E= 1.3 Therefore, D=1.3/2.33 =0.57, E=1/2.3 = 0.43

WACC= (E/V*Re+D)(D/V*Rd)*(1-Tax Rate)

Re= Cost of equity

Rd= Cost of Debt

E/V=Equity percentage of Financing

D/V=Debt percentage of Financing

7.1= (0.0.43*Re)+(0.57*6.6/100)*(1-35/100)

7.1= (0.43*Re)+(0.57*0.066)*(0.65)

7.1= (0.43*Re)+(0.024453)

7.1-0.024453=(0.43*Re)

7.075547=(0.43*Re)

Re=7.071257/ 0.43

Re= 16.45%

Therefore cost oc equity capital would be 16.45%

We need more information to calculate unlevered cost of capital. E.g. Levered Beta, Risk free rate and return on market.

Unlevered = Levered Beta / ( 1 + (D/E * (1-t)), where D and E are Market values, then use the unlevered Beta in the CAPM formula: r(e) = RFR + Unlevered Beta(Rm - RFR)

B-1. Cost of equity if Debt Equity Ratio is 2

D/E= 2 Therefore, D=2/3 =0.67, E=1/3 = 0.33

WACC= (E/V*Re+D)(D/V*Rd)*(1-Tax Rate)

7.1= (0.33*Re)+(0.67*6.6/100)*(1-35/100)

7.1= (0.33*Re)+(0.67*0.066)*(0.65)

7.1= (0.33*Re)+(0.0228743)

7.1-0.0228743=(0.33*Re)

7.071257=(0.33*Re)

Re=7.071257/ 0.33

Re= 21.43%

Cost of equity if Debt Equity Ratio is 2 would be 21.43%

B-2. Cost of equity if Debt Equity Ratio is 1

D/E= 1 Therefore, D=1/2 =0.5, E=1/2 = 0.5

WACC= (E/V*Re+D)(D/V*Rd)*(1-Tax Rate)

7.1= (0.5*Re)+(0.5*6.6/100)*(1-35/100)

7.1= (0.5*Re)+(0.5*0.066)*(0.65)

7.1= (0.5*Re)+(0.02145)

7.1-0.02145=(0.5*Re)

7.07855=(0.5*Re)

Re=7.07855/ 0.5

Re= 14.16%

Cost of equity if Debt Equity Ratio is 1 would be 14.16%

B-3. Cost of equity of Debt Equity Ratio is 0

D/E= 0 Therefore, D=0/1 =0, E=1/1 = 1

WACC= (E/V*Re+D)(D/V*Rd)*(1-Tax Rate)

7.1= (1*Re)+(0*6.6/100)*(1-35/100)

7.1= (1*Re)+(0*0.066)*(0.65)

7.1= (1*Re)+(0)

Re=7.1

Cost of equity if Debt Equity Ratio is 0 would be 7.1%

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