Skillet Industries has a debt–equity ratio of 1.8. Its WACC is 8.3 percent, and

Question

Skillet Industries has a debt–equity ratio of 1.8. Its WACC is 8.3 percent, and its cost of debt is 6.3 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

a. We assume the cost of debt and WACC are after tax

cost of equity :

WACC = equity /( debt + equity) * cost of equity + debt / (equity + debt) * cost of debt

     0.083 = 10/(18+10) * cost of equity + 18 / (18+10) * 0.063

0.083 = 10/ 28 * cost of equity + 18 / 28 *0.063

0.083 = 10/28*cost of equity + 0.04

   0.083 - 0.04 = 10/28 *cost of equity

     cost of equity = 12.04%

Note:-   debt - equity ratio = 1.8 or 18/10 ; debt = 18 and Equity = 10

therefore, total value = debt + equity

   = 18 + 10

b.   WACC =unleverage cost of equity ( 1 - debt / value * tax)

0.083 = unleverage cost of equity (1 - 18 / 28 * 0.35)

0.083 = unleverage cost of equity ( 1-0.22)

0.083 / 0.78 = unleverage cost of equity

  unleverage cost of equity = 10.64%

c.    a debt equity ratio = 2 , total value = debt + equity = 2 + 1 = 3

WACC = 1/ 3 * cost of equity + 2 /3 * 0.063

0.083 = 1/3*cost of equity + 0.04

( 0.083 - 0.04) * 3 = cost of equity

cost of equity=12.9%

b . debt equity ratio = 1 , total value = debt + equity = 1 + 1 = 2

WACC = 1/2 * cost of equity + 1/2 *0.063

0.083 = 1/2 *cost of equity + 0.0315

(0.083 - 0.0315 ) * 2 = cost of equity

  cost of equity = 10.3%

c debt equity ratio = 0 , total value = 1

WACC = 1 / 1 * cost of equity + 0/1*0.063

8.3% = cost of capital

Note: - cost of capital = WACC , when debt equity ratio is 0

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