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Homework answers / question archive / Johnson Fuel Systems has a weighted average cost of capital of 7
Johnson Fuel Systems has a weighted average cost of capital of 7.35%. Estimate Johnson's cost of equity given the following information: The firm's effective tax rate is 25%, they have an equal mix of debt and equity, the required return on the market portfolio is 9%, Johnson has a before-tax cost of debt of 6%, and the risk-free rate of return is 3%.
Computation of Johnson's Cost of Equity:
GIven,
Weighted Average Cost of Capital = 7.35%
Equal mix of equity and debt , which means that Weight of Debt = 0.50 and Weight of Equity =0.50
After Tax Cost of Debt = Before Tax Cost *(1-Tax Rate) = 6%*(1-0.25)= 4.5%
Weighted Average Cost of Capital = (Cost of Equity*Weight of Equity)+(After Tax Cost of Debt*Weight of Debt)
7.35% = (Cost of Equity * 0.50)+(4.5%*0.50)
7.35% = (Cost of Equity * 0.50)+ 2.25%
Cost of Equity * 0.50 = 7.35%-2.25%
Cost of Equity = 5.10%/0.50 = 10.20%
