Wesson Industries has a debt-equity ratio of 1.6. Its WASS is 15 percent, and it

Question

Wesson Industries has a debt-equity ratio of 1.6. Its WASS is 15 percent, and its cost of debt is 14 percent. The corporate tax rate is 35 percent. (round answers to 2 decimal places). I got (a) , (b) and part of (c), I just can't seem to get the right answers for the rest of (c).

(a). Wesson's cost of equity capital is 24.44 percent.

(b). Wesson's unlevered cost of equity capital is 19.12 percent.

(c). The cost of equity would be ________ percent if the debt-equity rato were 2, _________ percent if the debt-equity ratio were 1, and 19.12 percent if the debt-equity ratio were 0.

Explanation / Answer

(a). Wesson's cost of equity capital is 24.44 percent.

D/E = 1.6. So D = 1.6*E

so D/(D+E) = 1.6*E/(D+E) = 1.6*E/(1.6E+E) = 1.6/2.6 = 61.54%

So E/(D+E) = 100%-61.54% = 38.46%

So WACC = Wd*Kd*(1-T) + We*Ks

ie 15% = 61.54%*14%*(1-35%) + 38.46%*Ks

So Ks = (15% - 61.54%*14%*(1-35%))/38.46% = 24.44%

(b). Wesson's unlevered cost of equity capital is 19.12 percent.

ke = kul + [kul - kD]*[D/E]*[1 %u2013 t]

24.44% = kul + (kul - 14%)*1.6*(1-35%)

24.44% = kul + 1.04*kul - 14.56%

24.44% +14.56% = 2.04 kul

so kul = 19.12%

(c). The cost of equity would be 25.78% percent if the debt-equity rato were 2,

22.45% percent if the debt-equity ratio were 1,

and 19.12 percent if the debt-equity ratio were 0.

SOln as below:

With the D/E = 2 & Kul=19.12%

ke = kul + [kul - kD] [D/E] [1 %u2013 t]

ke = kul + [kul - 14%] [D/E] [1 %u201335%]

ke = 19.12% + (19.12% - 14%)*2.0*(1 -35%) = 25.78%

With the D/E = 1

ke = kul + [kul - kD] [D/E] [1 %u2013 t]

ke = kul + [kul - 14%] [D/E] [1 %u201335%]

ke =19.12% + (19.12% - 14%)*1.0*(1 -35%) = 22.45%

If the D/E = 0 then ke = kul = 19.12% [i.e., there is no leverage to consider]

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