- 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?
- 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%
