Skillet Industries has a debt–equity ratio of 1.2. Its WACC is 8.4 percent, and

Question

Skillet Industries has a debt–equity ratio of 1.2. Its WACC is 8.4 percent, and its cost of debt is 7.3 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))

Skillet Industries has a debt–equity ratio of 1.2. Its WACC is 8.4 percent, and its cost of debt is 7.3 percent. The corporate tax rate is 35 percent.

Explanation / Answer

if D/E = 1.2, then Debt to capital = D/E / (1+ D/E) = 1.2/2.2 = 0.55 <this is the weight of debt in WACC

recall the formula for WACC, WACC = We(Re) + Wd(Rd * (1 - t)),

where W=weight, R=rate, t=tax rate in decimal form

We = (1 - Wd), so... We = (1 - 0.55) = 0.45

next, substitute your values into the equation..

0.084 = 0.45Re + 0.55(0.073*0.65)

0.084 = 0.45Re + 0.026

0.084-0.026 = 0.45Re

0.084-0.026 = 0.45Re

0.058 = 0.45Re

Re = 12.88

Cross check

WACC = 0.45(0.1288) + 0.55(0.073(0.65)) = 0.0261 + 0.0580 = 0.84 or 8.4%

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)

.1288 = RU + (RU – .084)(1.2)(1 – .35)

RU = .1092   

Ru=10.92%

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:

.084= (1/3)RE+ (2/3)(.073)(1 – .35)

.084= (1/3)RE + .0316

RE= .1571 or 15.71%

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

.084 = (1/2)RE+ (1/2)(.073)(1 – .35)

.084 = (1/2)RE +.0237

=.1205

=12.05%

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

.084 = (1)RE+ (0)(.073)(1 – .35)

RE = WACC = .084 or 8.4%

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