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Dickson, Inc
Dickson, Inc., has a debt-equity ratio of 2.45. The firm's weighted average cost of capital is 10 percent and its pretax cost of debt is 8 percent. The tax rate is 21 percent.
a.What is the company's cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.
?)b.What is the company's unlevered cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c.What would the company's weighted average cost of capital be if the company's debt-equity ratio were .65 and 1.45? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
Expert Solution
WACC = 10%.
Cost of debt before tax = 8%
Tax rate = 21%
Debt to equity ratio = 2.45
Weight on debt = 2.45/(1+2.45)=2.45/3.45
=0.71
Weight on equity =1/(2.45+1)
=1/3.45
=.29
a.)
Assume,
Cost of equity = x
So,
WACC=.71*8*(1-.21) + .29*x =10 (given)
.71*8*.79+.29x =10
4.4872 +.29x =10
.29x= 5.5128
x= 5.5128/.29
=19.009
Hence,
Cost of equity is 19.01%
b.)
Levered cost of equity = Unlevered cost of equity + D/E * (unlevered cost of equity - Kd)*(1 - tax rate)
here,
D/E =debt to equity ratio
Kd =cost of debt
Cost of equity is also called as levered cost of equity.
So,
.1901= Unlevered cost of equity + 2.45*(unlevered cost of equity-.08)*(1-.21)
=>.1901=Unlevered cost of equity +2.45*(unlevered cost of equity-.08)*.79
=>.1901=Unlevered cost of equity + 1.9355*(unlevered cost of equity-.08)
=>.1901=Unlevered cost of equity + 1.9355*unlevered cost of equity -.15484
=>.1901+.15484=2.9355*unlevered cost of equity
=>.34494/2.9355=unlevered cost of equity
=>Unlevered cost of equity=.117506 or 11.75%
c.)
If debt to equity ratio becomes .65
Levered cost of equity = Unlevered cost of equity + D/E * (unlevered cost of equity - Kd)*(1 - tax rate)
=11.75% +.65*(11.75%-8%)*(1-21%)
=.1175+.65*(.1175-.08)*(1-.21)
=.1175+.65*.0375*.79
= 0.13676 or 13.68%
Weighted average cost of capital= .65/(1+.65)*8%*(1-21%) +1/(1+.65)*13.676%
=(.65/1.65)*.08(1-.21) + (1/1.65)*.13676
=(.65/1.65)*.08*.79 + (1/1.65)*.13676
=0.10778 or 10.78%
If debt to equity ratio becomes 1.45, then its levered cost of equity will be:
=11.75% +1.45*(11.75%-8%)*(1-21%)
=.1175+1.45*(.1175-.08)*(1-.21)
=.1175+1.45*.0375*.79
=0.16046 or 16.05%
Weighted average cost of capital= 1.45/(1+1.45)*.08(1-.21) + 1/(1+1.45)*0.16046
=1.45/2.45*.08*.79+1/2.45*0.16046
=0.10289
=10.29%
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