Crosby Industries has a debt-equity ratio of 1.3. Its WACC is 8 percent, and its

Question

Crosby Industries has a debt-equity ratio of 1.3. Its WACC is 8 percent, and its cost of debt is 5 percent. There is no corporate tax. Requirement 1: What is Crosby's cost of equity capital? (Do not round intermediate calculations. Input your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) Requirement 2: What would the cost of equity be if the debt-equity ratio were 2? (Do not round intermediate calculations. Input your answer as a percentage rounded to 2 decimal places (e.g., 32.16).) What would the cost of equity be if the debt-equity ratio were 0.6? (Do not round intermediate calculations. Input your answer as a percentage rounded to 2 decimal places (e.g., 32.16).] What would the cost of equity be if the debt-equity ratio were zero? (Do not round intermediate calculations. Input your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Explanation / Answer

After tax cost of debt = 5%

WACC = 8%

a.

Debt Equity ratio = 1:3

Proportion of debt in capital structure = 25%

Proportion of Equity in capital structure = 75%

WACC is calculated by using following formula:

                                WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt

8% = 25% ×5% + 75% ×Re

6.75% = 75% ×Re

         Re    = 9%

Hence cost of equity at debt equity ratio of 1:3 is 9%.

b.

Debt Equity ratio = 2:1

Proportion of debt in capital structure = 66.67%

Proportion of Equity in capital structure = 33.33%

Cost of equity is calculated bellow using WACC formula:

8% = 66.67% ×5% +33 .33% ×Re

4.67% = 33.33% ×Re

         Re    = 14.01%

Hence cost of equity at debt equity ratio of 2:1 is 14.01%.

c.

Debt Equity ratio = 0.6:1

Proportion of debt in capital structure = 37.5%

Proportion of Equity in capital structure = 62.5%

Cost of equity is calculated bellow using WACC formula:

8% = 37.5% ×5% +62 .50% ×Re

6.125% = 62.50% ×Re

         Re    = 9.80%

Hence cost of equity at debt equity ratio of 0.6:1 is 9.80%.

d.

Debt Equity ratio = 0

Proportion of debt in capital structure = 0%

Proportion of Equity in capital structure = 100%

Cost of equity is calculated bellow using WACC formula:

8% = 0% ×5% +100% ×Re

8% = 1000% ×Re

         Re    = 8%

Hence cost of equity at debt equity ratio of 0 is 8%.

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