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

Question

Skillet 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.

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

b. What is the company’s unlevered cost of equity capital?

c-1 What would the cost of equity be if the debt–equity ratio were 2?

c-2 What would the cost of equity be if the debt–equity ratio were 1.0?

c-3 What would the cost of equity be if the debt–equity ratio were zero?

Explanation / Answer

a) Debt/equity = 1.4
Weight of Debt= 1.4/2.4 & weight of equity = 1/2.4

WACC = 8%

WACC = (E/V)Re + (D/V)Rd(1 – tc)
.08= (1/2.4)Re + (1.4/2.4).059(1-.35) = 13.83%

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)
.1383=Ru + (Ru-.059)(1.4)(1-.35)
Ru = 10.05%

c) To find the cost of equity under different capital structures, we can again use the WACC equation.

C-1)With a debt-equity ratio of 2, the cost of equity is:

.08 = (1/3)RE + (2/3)(.059)(1 – .35) = 16.33%

C-2) With a debt-equity ratio of 1.0, the cost of equity is:

.08 = (1/2)RE + (1/2)(.059)(1 – .35) = 12.16%

C-3) And with a debt-equity ratio of 0, the cost of equity is:

.08 = (1)RE + (0)(.059)(1 – .35) = 8%

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