Question

Kose, Inc., has a target debt-equity ratio of .45. Its WACC is 8.8 percent, and the tax rate is 24 percent. a. If the company’s cost of equity is 11 percent, what is its pretax cost of debt? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. If instead you know that the aftertax cost of debt is 6.2 percent, what is the cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

It is given that debt-equity ratio is 0.45. So, weight of equity will be (1/1.45) and weight of debt will be (0.45/1.45).

The formula for weighted average cost of capital can be used to calculate pretax cost of debt.

[(Weight of equity xCost of equity) WACC = +(Weight of debt x Before tax cost of debt x (1 – Tax rate)

Substitute 8.8% for WACC, 11% for cost of equity, (1/1.45) for weight of equity, (0.45/1.45) for weight of debt and 24% for tax rate in the above expression,

8.8%=1 (1.45 10.45 1% + ** Before tax cost of debt x(1-24° (1.45 11% 0.342x Before tax cost of debt 8.8% =- 1.45 1.45 8.8%x1.45 =11%+0.342 Before tax cost of debt 12.76%-11%=0.342x Before tax cost of debt 0.0514619 = Before tax cost of debt

Thus, before tax cost of debt will be 5.14%.

Again, the cost of equity can be calculated with the help of WACC formula,

|(Weight of equity ~ Cost of equity) WACC = +(Weight of debtx After tax cost of debt)

The cost of equity is calculated below:

m 1 (0.45 8.8%= -x Cost of equity + x 6.2% L 1.45 (1.45 8.8%-Cost of equity 0.0279 1.45 1.45 8.8%x1.45 = Cost of equity + 0.0279 0.1276 -0.0279 = Cost of equity 0.0997 = Cost of equity

Thus, the cost of equity will be 9.97%.