Kose, Inc., has a target debt–equity ratio of 1.25. Its WACC is 8.5 percent, and

Question

Kose, Inc., has a target debt–equity ratio of 1.25. Its WACC is 8.5 percent, and the tax rate is 38 percent. a. If Kose’s cost of equity is 12 percent, what is its pretax cost of debt? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16)) Cost of debt % b. If instead you know that the aftertax cost of debt is 3.6 percent,

what is the cost of equity? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

Cost of equity: %

Explanation / Answer

Debt equity ratio = 1.25

Weight of Debt = 1.25/2.25

Weight of Equity = 1/2.25

a. WACC = Cost of Debt * Weight of Debt + Cost of Equity * Weight of equity

8.5% = Cost of debt * 1.25/2.25 + 12% * 1/2.25

Cost of Debt = (8.5% - 5.33%) * 2.25/1.25 = 5.706%

This is after tax Cost of Debt.

Pretax Cost of Debt = 5.706% *100/62 = 9.20% (approx)

b.

WACC = Cost of Debt * Weight of Debt + Cost of Equity * Weight of equity

8.5% = 3.60% * 1.25/2.25 + Cost of Equity * 1/2.25

Cost of Equity = (8.5% - 2%) * 2.25/1 = 14.625%

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