Problem 14-14 WACC [LO3] Fyre, Inc., has a target debtequity ratio of 1.45. Its
ID: 2752945 • Letter: P
Question
Problem 14-14 WACC [LO3]
Fyre, Inc., has a target debtequity ratio of 1.45. Its WACC is 8.1 percent, and the tax rate is 40 percent.
If the company’s cost of equity is 16 percent, what is its pretax cost of debt? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
If instead you know that the aftertax cost of debt is 4 percent, what is the cost of equity? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Fyre, Inc., has a target debtequity ratio of 1.45. Its WACC is 8.1 percent, and the tax rate is 40 percent.
Explanation / Answer
Debt-equity ratio = 1.45
D / E = 1.45
D = 1.45E
Total capital, (D + E) = 1.45E + E = 2.45E
Proportion of debt = 1.45E / 2.45E = 59.18%
Proportion of equity = (100 - 59.18)% = 40.82%
(a)
WACC = Proportion of debt x post-tax Cost of debt + Proportion of equity x cost of equity
= 59.18% x Pre-tax cost of debt x (1 - tax rate) + 40.82% x 16%
8.1% = 59.18% x Pre-tax cost of debt x (1 - 0.4) + 6.53%
1.57% =Pre-tax cost of debt x 59.18% x 0.6 = Pre-tax cost of debt x 35.51%
Pre-tax cost of debt = 1.57% / 35.51% = 4.42%
(b) post-tax cost of debt = 4%
8.1% = 59.18% x 4% + 40.82% x Cost of equity
40.82% x Cost of equity = 8.1% - 2.37% = 5.73%
Cost of equity = 5.73% / 40.82% = 14.04%