Consider a firm that has a debt-to-equity ratio of 2

Finance Aug 23, 2020

Consider a firm that has a debt-to-equity ratio of 2.00. The firm's WACC is currently 12 percent, its cost of debt is 6 percent, and the tax rate is 35%. What is this firm's cost of equity?

Expert Solution

Computation of the cost of equity:-

Debt-to-equity ratio = 2

Weight of debt = 2 / (1+2)

= 0.67

Weight of equity = 1 / (1+2)

= 0.33

WACC = (Weight of debt * After tax cost of debt) + (Weight of equity * Cost of equity)

12% = (0.67 * 6% * (1 - 35%)) + (0.33 * Cost of equity)

0.33 * Cost of equity = 12% - 2.60%

Cost of equity = 9.40% / 0.33

= 28.20%

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