Skillet Industries has a debt–equity ratio of 1.1. Its WACC is 8.2 percent, and

Question

Skillet Industries has a debt–equity ratio of 1.1. Its WACC is 8.2 percent, and its cost of debt is 6.4 percent. The corporate tax rate is 35 percent.

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

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

What would the cost of equity be if the debt–equity ratio were 2? (Round your answer to 2 decimal places. (e.g., 32.16))

What would the cost of equity be if the debt–equity ratio were 1.0? (Round your answer to 2 decimal places. (e.g., 32.16))

What would the cost of equity be if the debt–equity ratio were zero? (Round your answer to 2 decimal places. (e.g., 32.16))

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

Explanation / Answer

(a) WACC = 8.2%

Cost of Debt = 6.4%

Debt to Equity ratio = 1.10

Hence weight of Debt = 1.10 /(1.10+1) = 0.5238

And Weight of Equity = 1-0.5238 = 0.4762

Using the WACC formula:

WACC = Cost of equity * weight of equity + Cost of debt * weight of debt

Hence ,

8.2 = Cost of equity *0.4762 + 6.4*0.5238

Cost of equity = (8.2-3.35)/0.4762

cost of equity = 4.85 / 0.4762 = 10.18%

(b) Unlevered cost of equity capital

Using the formula:

Ke (levered) = Ke (Unlevered) + (Debt / Equity) *( Ke (Unlevered) - Cost of debt)

Ke (levered) is = 10.18%

Cost of debt = 6.4%

Debt to equity = 1.1

Hence ,

10.18 = Ke (Unlevered) + 1.1 *( Ke (Unlevered) - 6.4)

Ke (Unlevered) + 1.1 * Ke (Unlevered - 7.04 = 10.18

2.1 * Ke (Unlevered) = 17.22

Ke (Unlevered) = 17.22 / 2.1 = 8.20%

(c-1)

WACC = 8.2%

Cost of Debt = 6.4%

Debt to Equity ratio = 2

Hence weight of Debt = 2 /(2+1) = 0.66666

And Weight of Equity = 1-0.66666 = 0.33333

Using the WACC formula:

WACC = Cost of equity * weight of equity + Cost of debt * weight of debt

Hence ,

8.2 = Cost of equity *0.33333 + 6.4*0.66666

Cost of equity = (8.2 - 4.266 ) /0.33333 = 11.80%

(c-2)

WACC = 8.2%

Cost of Debt = 6.4%

Debt to Equity ratio = 1

Hence weight of Debt =1 /(1+1) = 0.50

And Weight of Equity = 1-0.50 = 0.50

Using the WACC formula:

WACC = Cost of equity * weight of equity + Cost of debt * weight of debt

Hence ,

8.2 = Cost of equity *0.50 + 6.4*0.50

Cost of equity = (8.2 - 3.20 ) /0.50 = 10.00%

(C-3) Debt to equity rate zero means Unlevered equity hence cost of unlevered equity shall be = 8.20%

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