Twice Shy Industries has a debtequity ratio of 1.2. Its WACC is 9 percent, and i

Question

Twice Shy Industries has a debtequity ratio of 1.2. Its WACC is 9 percent, and its cost of debt is 5.7 percent. The corporate tax rate is 35 percent. a. 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.) Cost of equity capital % b. 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.) Unlevered cost of equity capital % c-1 What would the cost of equity be if the debtequity ratio were 2? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity % c-2 What would the cost of equity be if the debtequity ratio were 1.0? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity % c-3 What would the cost of equity be if the debtequity ratio were zero?

Explanation / Answer

4.      a.     With the information provided, we can use the equation for calculating WACC to find the cost of equity. The equation for WACC is:

         WACC = (E/V)RE + (D/V)RD(1 – tC)

         The company has a debt-equity ratio of 1.2, which implies the weight of debt is 1.2/2.2, and the weight of equity is 1/2.2, so

         WACC = .09 = (1/2.2)RE + (1.2/2.2)(.057)(1 – .35)

         RE = .1535 or 15.35%

b.    To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so:

         RE = RU + (RU – RD)(D/E)(1 – tC)

         .1535 = RU + (RU – .057)(1.2)(1 – .35)

         RU = .1112 or 11.12%

c.    To find the cost of equity under different capital structures, we can again use the WACC equation. With a debt-equity ratio of 2, the cost of equity is:

         .09 = (1/3)RE + (2/3)(.057)(1 – .35)   

         RE = .19590 or 19.59%

         With a debt-equity ratio of 1.0, the cost of equity is:

         .09 = (1/2)RE + (1/2)(.057)(1 – .35)     

         RE = .1429 or 14.29%

         And with a debt-equity ratio of 0, the cost of equity is:

         .09= (1)RE + (0)(.057)(1 – .35)      

         RE = WACC = .09or 9%

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