wice Shy Industries has a debtequity ratio of 1.7. Its WACC is 9.2 percent, and

Question

wice Shy Industries has a debtequity ratio of 1.7. Its WACC is 9.2 percent, and its cost of debt is 6.2 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 18 % 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 11.8 % 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 19.5 % 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 14.37 % c-3 What would the cost of equity be if the debtequity ratio were zero? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity 9.2 %

Explanation / Answer

a.    

The company has a debt-equity ratio of 1.7,

Debt = 1.7*Equity

Debt + Equity = 1.7*Equity + Equity = 2.7*Equity

Weight of equity = Equity/(Debt + Equity) = Equity / 2.7 equity = 1/2.7

Weight of debt = 1 – 1/2.7 = 1.7/2.7

WACC = 9.2% = 0.092

Cost of debt = 6.2% = 0.062

After tax cost of debt = 0.062*(1-0.35) = 0.0403

WACC = (Cost of equity*Weight of equity) + (Cost of debt*Weight of debt)       0.092 = (Cost of equity*1/2.7) + (0.0403*1.7/2.7)

Cost of equity = 0.1799 = 18%

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

Cost of equity = Cost of unlevered equity + (Cost of unlevered equity-Cost of debt)*Debt/Equity*(1-tax rate)

0.18 = Cost of unlevered equity + (Cost of unlevered equity-0.062)*1.7*0.65

0.18 = Cost of unlevered equity + 1.105*Cost of unlevered equity -0.06851

Cost of unlevered equity = 0.118057 = 11.8%

c-1.

Debt-Equity ratio = 2

Debt = 2*Equity

Weight of equity = 1/3

Weight of debt = 2*1/3 = 2/3

Using the WACC formula,

0.092 = (1/3)Cost of equity + (2/3)(0.062)(1 – .35)   

0.092 = (1/3)Cost of equity + 0.02687

Cost of equity = 0.1954 = 19.54%

c-2.

Debt-Equity ratio = 1

Debt = Equity

Weight of equity = 1/2

Weight of debt = 1/2

Using the WACC formula,

0.092 = (1/2)Cost of equity + (1/2)(0.062)(1 – .35)   

0.092 = (1/2)Cost of equity + 0.02015

Cost of equity = 0.1437 = 14.37%

C-3.

Debt-Equity ratio = 0

Debt = 0

Weight of equity = 1

Weight of debt = 0

Using the WACC formula,

0.092 = Cost of equity + 0*(0.062)(1 – .35)   

Cost of equity = 0.092 = 9.20%

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