- Moon Beam Industries has a debt-equity ratio of 1.5. Its WACC is 12 percent, and its cost of debt is 12 percent. The corporate tax rate is 35 percent.
- What is Moon Beam’s cost of equity capital?
- What is Moon Beam’s unlevered cost of equity capital?
- What would the cost of equity be if the debt-equity ratio were 2? What if it were 1.0? What if it were zero?
a. With the information provided, we can use the equation for calculating WACC to find the cost of equity. The equation 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 is 1/2.5, so
WACC = .12 = (1/2.5)RE + (1.5/2.5)(.12)(1 – .35)
RE = .1830 or 18.30%
- To find the unlevered cost of equity we need to use M&M Proposition II with taxes, so:
RE = RU + (RU – RD)(D/E)(1 – tC)
.1830 = RU + (RU – .12)(1.5)(1 – .35)
RU = .1519 or 15.19%
- To find the cost of equity under different capital structures, we can again use the WACC equation. With a debt-equity ratio of 2, the cost of equity is:
.12 = (1/3)RE + (2/3)(.12)(1 – .35)
RE = .2040 or 20.40%
With a debt-equity ratio of 1.0, the cost of equity is:
.12 = (1/2)RE + (1/2)(.12)(1 – .35)
RE = .1620 or 16.20%
And with a debt-equity ratio of 0, the cost of equity is:
.12 = (1)RE + (0)(.12)(1 – .35)
RE = WACC = .12 or 12%