If the debt-equity ratio is revised from 0.54 to 0.65, the cost of equity will be 11.95%.
Data and Calculations:
Debt-equity ratio = 0.54
Weight of equity = 0.46 (1 - 0.54)
Cost of equity = 15.7%
Pretax cost of debt = 6.8%
Tax rate = 22%
Post-tax cost of debt = 5.3% (6.8% (1 - 22%)
Revised debt-equity ratio = 0.65
Revised weight of equity = 0.35 (1 - 0.65)
Thus, if the cost of equity is 15.7% when equity ratio is 0.46, then the cost of equity will be 11.95% (15.7%/0.46 x 0.35) when the equity ratio revises to 0.35.
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The cost of equity would 16.43% if the debt equity is revised to 0.65
Solution
The debt equity ratio = 0.54
To get the cost of the debt post tax:
= 6.8%*(1-0.22)
= 0.068*0.78
= 0.05304
= 5.304%
Next we are to get the WACC
[tex]WACC= 15.7percent*\frac{1}{1+0.54} *5.304percent*\frac{0.54}{1+0.54}[/tex]
WACC = 0.157*0.6494+0.05304*0.3506
= 0.1205
= 12.05%
Since the Debt equity ratio is revised to 0.65 and WACC stays the same
We would have
[tex]12.05percent = Ke*\frac{1}{1+0.65} +5.304percent*\frac{0.65}{1+0.65}[/tex]
0.1205 = Ke*0.606+0.05304*0.3939
0.1205 = 0.606Ke + 0.02089
We collect like terms
0.1205-0.02089 = 0.606Ke
0.09961 = 0.606Ke
Ke = 0.1643
= 16.43 percent
The cost of equity would 16.43% if the debt equity is revised to 0.65
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