Weston Industries has a debt–equity ratio of 1.1. Its WACC is 7.0 percent, and i

Question

Weston Industries has a debt–equity ratio of 1.1. Its WACC is 7.0 percent, and its cost of debt is 5.6 percent. The corporate tax rate is 35 percent.

What is Weston’s cost of equity capital? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

What is Weston’s unlevered cost of equity capital? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

What would the cost of equity be if the debt–equity ratio were 2? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

What would the cost of equity be if the debt–equity ratio were 1.0? (Do not round intermediate calculations and round your final answer 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 and round your final answer to 2 decimal places. (e.g., 32.16))

Weston Industries has a debt–equity ratio of 1.1. Its WACC is 7.0 percent, and its cost of debt is 5.6 percent. The corporate tax rate is 35 percent.

Explanation / Answer

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 1.1, which implies the weight of debt is 1/2, and the weight of equity is 1/2, so

         WACC = .07 = (1/2)RE + (1/2)(.056)(1 – .35)

         RE = .1036 or 10.36%

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)

         .1036 = RU + (RU – .056)(1/2)(1 – .35)

.1036 = RU + (RU – .056)0.325

.1036 + 0.182 = 1.325RU

RU = 0.215547

         RU = .215547 or 21.55%

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:

         .07 = (1/3)RE + (2/3)(.056)(1 – .35)   

         RE = .1372 or 13.72%

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

         .07 = (1/2)RE + (1/2)(.056)(1 – .35)     

         RE = .1036 or 10.36%

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

         .07 = (1)RE + (0)(.056)(1 – .35)      

         RE = WACC = .14 or 14%

.1036 = RU + (RU – .056)0.325

.1036 + 0.182 = 1.325RU

RU = 0.215547

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