Maxwell Industries has a debt-equity ratio of 1.5. Its WACC is 10 percent, and i

Question

Maxwell Industries has a debt-equity ratio of 1.5. Its WACC is 10 percent, and its cost of debt is 8 percent. The corporate tax rate is 35 percent. (Do not include the percent signs (%). Round your answers to 2 decimal places. (e.g., 32.16)) Required: a. Maxwell's cost of equity capital is percent. b. Maxwell's unlevered cost of equity capital is percent. c. The cost of equity would be ___ percent if the debt-equity ratio were 2, ___percent if the debt-equity ratio were 1, and ___percent if the debt-equity ratio were 0.

Explanation / Answer

With the information provided, we can use the equation for calculating WACC to find the cost of equity. Theequation for WACC is:WACC = (E/V)RE+ (D/V)RD(1 – tC)

The company has a debt-equity ratio of 1.5, which implies the weight of debt is 1.5/2.5, and the weight of equity is1/2.5, so

WACC = .10 = (1/2.5)RE+ (1.5/2.5)(.07)(1-0.35)=

RE= .1818 or 18.18%

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b.

To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so:R

E= RU+ (RU  – RD)(D/E)(1 – tC).1818 = RU+ (RU  – .07)(1.5)(1 – .35)RU= .1266 or 12.66%

c.

To find the cost of equity under different capital structures, we can again use M&M Proposition II with taxes. Witha debt-equity ratio of 2, the cost of equity is:

RE= RU+ (RU  – RD)(D/E)(1 – tC)RE= .1266 + (.1266 – .07)(2)(1 – .35)RE

= .2001 or 20.01%With a debt-equity ratio of 1.0, the cost of equity is:R

E= .1266 + (.1266 – .07)(1)(1 – .35)

RE= .1634 or 16.34%

And with a debt-equity ratio of 0, the cost of equity is:R

E= .1266 + (.1266 – .07)(0)(1 – .35)RE= RU= .1266 or 12.66%

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