Weston Industries has a debt-equity ratio of 1.8. Its WACC is 11 percent, and it

Question

Weston Industries has a debt-equity ratio of 1.8. Its WACC is 11 percent, and its cost of debt is 10 percent. The corporate tax rate is 33 percent. (Do not include the percent signs (%). Round your answers to 2 decimal places. (e.g., 32.16)) Required: a. Weston’s cost of equity capital is percent. b. Weston’s unlevered cost of equity capital is percent. c. The cost of equity would be percent if the debt-equity ratio were 2, percent if the debt-equity ratio were 1, and percent if the debt-equity ratio were 0.

Explanation / Answer

solution :

To compute the western's cost of equity :

Debt /Equity = 1.8

D = 1.8 E, so D/[D+E] = 1.8E/[1.5E + E] = 1.8/2.8 = .6428 or 64.28%
E/[D+E] = 1 - .64 = .36 or 36%
Therefore, WACC = .64 x .10 x (1-.33) + .36 ke
.11 = .0428 + . 36 ke
.1864 = ke

Hence Ke = 18.64%

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

To find the unlevered cost of equity we use the M&M Proposition 2 with taxes:
ke = kul + [kul - kD] [D/E] [1 – t]
.186 = kul + [kul - .10] [1.8] [1 –.33]
.183 = kul + 1.206 kul - .120
.303= 2.206 kul
13.76% = kul

c. Using the information and the same methodology as in (b) with the M&M

With the D/E = 2
ke = kul + [kul - kD] [D/E] [1 – t]
ke = kul + [kul - .10] [D/E] [1 –.33]
ke = .1376 + [.1376 - .10] [2.0] [1 –.33] = .1879 or 18.79%

With the D/E = 1
ke = kul + [kul - kD] [D/E] [1 – t]
ke = kul + [kul - .12] [D/E] [1 –.33]
ke = .1376 + [.1376 - .10] [1.0] [1 –.33] = ..1627 or 16.27%

If the D/E = 0 then ke = kul = 13.76% [i.e., there is no leverage to consider]

Thank you

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