Skillet Industries has a debt-equity ratio of 1.4. Its WACC is 9.4%, and its cos

Question

Skillet Industries has a debt-equity ratio of 1.4. Its WACC is 9.4%, and its cost of debt is 6.7%. The corporate tax rate is 35%.

(A.) What is the company's cost of equity capital? (Round your answer to 2 decimal places)

(B.) What is the company's unlevered cost of equity capital? (Round your answer to 2 decimal places)

(C-1) What would the cost of equity be if the debt-equity ratio were 2? (Round your answer to 2 decimal places)

(C-2) What would the cost of equity be if the debt-equity ratio were 1.0? (Round your answer to 2 decimal places)

(C-3) What would the cost of equity be if the debt-equity ratio were zero? (Round your answer to 2 decimal places)

Explanation / Answer

(‘1) Cost of Equity

We know that

Weight of Debt = Debt / ( Debt + Equity) = D/E / (1+ D/E)

Weight of Debt (Wd ) = 0.25 / (1.25)

Weight of Debt = 0.20

Hence Weight of Equity = 1- Weight of debt

Weight of Equity ( We ) = 0.8

WACC = Wd x Kd x ( 1- Tax ) + We x Ke

0.094 = 0.20 x 6.7 x (1-0.35 ) + 0.80 x Ke

By solving this We get

Cost of Equity ( Ke ) = 10.66 %

(‘2) Unlevered Cost of Equity

We know that

WACC= x ( 1- D/V x T)

Where ( rho) is the Unlevered cost of equity

D/ V = Debt ratio in capital structure here D/V= 0.20

T= tax rate = 35 %

WACC = 9.4 %

Hence

9.4 = x [ 1- (0.2 x 0.35 ) ]

9.4 = x 0.93

( Cost of unlevered equity ) = 10. 11 %

(‘3) Cost of Equity when debt to equity is 2

Debt / Equity = 2

This means Debt ratio to entire capital= 2/3

Equity ratio to entire capital = 1/3

WACC = Wd x Kd x ( 1- Tax ) + We x Ke

9.4 = 2/3 x 6.7 x (1-0.35 ) + 1/3 x Ke

Ke = 19.49 %

(‘4) Cost of Equity when debt to equity is 1

Debt / Equity= 1

Debt = Equity

WACC = Wd x Kd x ( 1- Tax ) + We x Ke

9.4 = 0.5 x 6.7 x (1-0.35) + 0.5 x Ke

Ke = 14.45 %

(‘5) Cost of Equity when debt to equity is 0

It means capital structures consist only equity

Equity = 100 %

Debt = 0 %

WACC = Wd x Kd x ( 1- Tax ) + We x Ke

9.4 = 0+ 1 x Ke

Ke = 9.4 %

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