Question

A firm uses only debt and equity in its capital structure. The firm's weight of debt is 40%. The firm could issue new bonds at a yield to maturity of 9% and the firm has a tax rate of 30%. If the firm's WACC is 11%, what is the firm's cost of equity

Answer 1

rE = 0.141333333 or 14.133333% rounded off to 14.13%

Step-by-step explanation:

The WACC or Weighted average cost of capital is the cost of a firm's capital structure that can be made of one or all of the following components namely debt, preferred stock and common equity.

The formula to calculate is as follows,

WACC = wD * tD * (1- tax rate) + wP * rP + wE * rE

Where,

• w represents the weight of each component in capital structure

• r represents the cost of each component

• D, P and E represents debt, preferred stock and Common Equity respectively.

As the debt weight is 40%, the equity weight will be 1 - 40% = 60%

As we don't have preferred stock so our WACC equation will be,

WACC = wD * tD * (1- tax rate) + wE * rE

Plugging in the values in the formula,

0.11 = 0.4 * 0.09 * (1 - 0.3) + 0.6 * rE

0.11 = 0.0252 + 0.6 * rE

0.11 - 0.0252 = 0.6 * rE

0.0848 / 0.6 = rE

rE = 0.141333333 or 14.133333% rounded off to 14.13%