Question

Weston Industries has a debt-to-shareholders' equity ratio of 1.6. Its WACC is 8.6 percent, and its cost of debt before taxes is 6.1 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 percentage rounded to two decimal places, for example, 32.16.)
b. What is the company's unlevered cost of equity capital? (Do not round intermediate calculations. Enter your answer as a percentage rounded to two decimal places, for example, 32.16.)
c-1 What would be the cost of shareholders' equity if the debt-shareholders' equity ratio were 2? (Do not round intermediate calculations. Enter your answer as a percentage rounded to two decimal places, for example, 32.16.)
c-2. What would be the cost of stockholders' equity if the debt-shareholders' equity ratio were 1.0? (Do not round intermediate calculations. Enter your answer as a percentage rounded to two decimal places, for example, 32.16.)
c-3. What would be the cost of stockholders' equity if the debt-shareholders' equity ratio were zero? (Do not round intermediate calculations. Enter your answer as a percentage rounded to two decimal places, for example, 32.16.)

Answer 1

a) The cost of equity capital is 7.95%. b) The unlevered cost of equity capital is 3.90%. c-1) The cost of shareholders' equity with a debt-to-equity ratio of 2 is 7.3%. c-2) The cost of shareholders' equity with a debt-to-equity ratio of 1.0 is 7.95%. c-3) The cost of stockholders' equity with a debt-to-equity ratio of zero is also 7.95%.

Step-by-step explanation:

a) To calculate the company's cost of equity capital, we can use the following formula:

Cost of Equity = WACC - (Debt-to-Equity Ratio x (1 - Tax Rate) x (WACC - Cost of Debt))

Plugging in the given values, the cost of equity capital is:

Cost of Equity = 8.6% - (1.6 x (1 - 0.35) x (8.6% - 6.1%))

Cost of Equity = 8.6% - (1.6 x 0.65 x 2.5%)

Cost of Equity = 8.6% - 0.65%

Cost of Equity = 7.95%

b) The unlevered cost of equity capital can be calculated by using the following formula:

Unlevered Cost of Equity = Cost of Equity / (1 + (Debt-to-Equity Ratio x (1 - Tax Rate)))

Plugging in the given values, the unlevered cost of equity capital is:

Unlevered Cost of Equity = 7.95% / (1 + (1.6 x (1 - 0.35)))

Unlevered Cost of Equity = 7.95% / (1 + (1.6 x 0.65))

Unlevered Cost of Equity = 7.95% / (1 + 1.04)

Unlevered Cost of Equity = 7.95% / 2.04

Unlevered Cost of Equity = 3.90%

c-1) If the debt-to-equity ratio were 2, the cost of shareholders' equity can be calculated using the same formula as in part a:

Cost of Equity = 8.6% - (2 x (1 - 0.35) x (8.6% - 6.1%))

Plugging in the values, the cost of shareholders' equity is:

Cost of Equity = 8.6% - (2 x 0.65 x 2.5%)

Cost of Equity = 8.6% - 1.3%

Cost of Equity = 7.3%

c-2) If the debt-to-equity ratio were 1.0, the cost of shareholders' equity can be calculated using the same formula as in part a:

Cost of Equity = 8.6% - (1.0 x (1 - 0.35) x (8.6% - 6.1%))

Plugging in the values, the cost of shareholders' equity is:

Cost of Equity = 8.6% - (1.0 x 0.65 x 2.5%)

Cost of Equity = 8.6% - 0.65%

Cost of Equity = 7.95%

c-3) If the debt-to-equity ratio were zero, there would be no debt and the cost of stockholders' equity would be the same as the cost of equity capital. Therefore, the cost of stockholders' equity would be 7.95%.