Twice Shy Industries has a debt?equity ratio of 1.4. Its WACC is 8 percent, and

Question

Twice Shy Industries has a debt?equity ratio of 1.4. Its WACC is 8 percent, and its cost of debt is 5.9 percent. The corporate tax rate is 35 percent.

What is the company’s cost of equity capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What is the company’s unlevered cost of equity capital? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What would the cost of equity be if the debt?equity ratio were 2? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What would the cost of equity be if the debt?equity ratio were 1.0? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What would the cost of equity be if the debt?equity ratio were zero? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Twice Shy Industries has a debt?equity ratio of 1.4. Its WACC is 8 percent, and its cost of debt is 5.9 percent. The corporate tax rate is 35 percent.

Explanation / Answer

a) WACC = Weight of debt * Cost of Debt * (1 - Tax rate) + Weight of Equity * Cost of Equity

In question, Debt-to-equity = 1.4

So Weight of debt = 1.4/(1 + 1.4) = 58.33%

Weight of Equity = 1/(1 + 1.4) = 41.67%

8% = 58.33% * 5.9% * (1 - 35%) + 41.67% * Cost of Equity

Cost of Equity = 5.76%/41.67% = 13.83%

b) Unlevered Cost of Equity

To find the unlevered cost of equity, using information in question and levered cost of equity we calculated, we need to use Miller Modigliani proposition with taxes.

RL = RU + (RU - RD)(D/E)(1 - Tax rate)

RU is unlevered cost of equity

RL is levered cost of equity

13.83% = RU + (RU - 5.9%)(1.4)(1 - 35%)

13.83% = RU + (RU - 5.9%)(0.91)

13.83% = RU + (0.91RU - 5.369%)

1.91RU = 19.2%

RU = 10.05%

c-1) Levered Cost of Equity if D/E = 2

RL = RU + (RU - RD)(D/E)(1 - Tax rate)

RL = 10.05% + (10.05% - 5.9%)(2)(1 - 35%)

RL = 15.45%

c-2) Levered Cost of Equity if D/E = 1

RL = RU + (RU - RD)(D/E)(1 - Tax rate)

RL = 10.05% + (10.05% - 5.9%)(1)(1 - 35%)

RL = 12.75%

c-3) Levered Cost of Equity if D/E = 0

RL = RU + (RU - RD)(D/E)(1 - Tax rate)

RL = 10.05% + (10.05% - 5.9%)(0)(1 - 35%)

RL = 10.05%

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