1) Williamson Inc. has a debt-to-equity ratio of 2.5. The firm’s weighted averag
ID: 2758134 • Letter: 1
Question
1) Williamson Inc. has a debt-to-equity ratio of 2.5. The firm’s weighted average cost of capital (WACC) is 14%, and its pretax cost of debt is 8%. The corporate tax rate is 40%. a) At its present capital structure, what is Williamson Inc.’s stockholder required return (i.e. cost of equity capital)? b) Assume that Williamson adjusts its capital structure and no longer has any outstanding debt. With no debt in the capital structure, what is Williamson Inc.’s stockholder required return (i.e. cost of equity capital)? c) What would Williamson’s weighted average cost of capital (WACC) equal if the firm’s debt-to-equity ratio changes from 2.5 to 0.75 (assume the cost of debt remains at 8%)?
Explanation / Answer
a. WACC = Rd * Weight of Debt + Re * Weight of Equity
14% = 8%(1-0.40) * 2.5/3.5 + Re * 1/3.5
14% = 3.43% + Re * 1/3.5
Return on Equity = 37% (approx)
b. When there is no debt, the weight of equity would be 1 and weight of equity 0. Therefore, the entire cost of capital is return on equity = 14%.
c.
WACC = Rd * Weight of Debt + Re * Weight of Equity
14% = 8%(1-0.40) * 0.75/1.75 + Re * 1/1.75
14% = 2.06% + Re * 1/1.75
Return on Equity = 20.90% (approx)
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