Question

Brown Industries has a debt-equity ratio of 1.5. Its WACC is 9.6 percent, and its cost of debt is 5.7 percent. There is no corporate tax. a. What is the company's cost of equity capital

Answer 1

Answer:

Cost of equity capital is 0.122 or 12.2%

Explanation:

The WACC or weighted average cost of capital is the cost of a company's capital structure. The capital structure may contain one, two or all of the following components namely debt, preferred stock and common equity. The WACC is calculated by taking the weighted average of the each components cost.

WACC = wD * rD * (1 - tax rate)  +  wP * rP  +  wE * rE

Where,

• w represents the weight of each component
• r represents the cost of each component
• D, P and E represent debt, preferred stock and common equity respectively

To calculate the cost of equity capital, we first need to find out the weight of each component in the capital structure.

debt to equity = 1.5

So, debt = 1

equity = 1.5

Total assets = 1 + 1.5   = 2.5

wD = 1/2.5  = 0.4

wE = 1.5/2.5  =0.6

Using the WACC formula,

0.096 = 0.4 * 0.057  +  0.6 * rE

0.096 = 0.0228 + 0.6 * rE

0.096 - 0.0228 = 0.6 * rE

0.0732 / 0.6 = rE

rE = 0.122 or 12.2%