Debt = 0.5 Equity = 0.50, so D/E = 1 Wacc = 10 Pretax cost of debt = 5 tax = 0.2 What is the cost of equity? Now using equation 9 we should get: Re = 10 + (10-5)*0.8*(50/50) = 14 But using Equation 1 we get: 10 = 0.5*5*0.8 + 0.5*Re So Re = 16 Which equation do we use? They give different answers.
i believe equation 9 is re for a company after it takes on debt, given its r0 which you may call wacc with no debt That is not what you are given in question 3. You have the wacc that takes into account your debt aleady. So you use the wacc formula you have know for ever. Sorry if i am no help. I always get stuff but to explain. I am workin to build that skill
yeah, equation 1 is for rwacc, cost of debt AND equity. Equation 9 is just cost of equity, which the problem asks for.
yes, equation 9 is just the WACC formula without taxes, and we are solving for Re or cost of equity, because as companies increase their use of debt, the risk to equityholders increases, which in turn increases the cost of equity. Therefore, the benefits of using a larger proportion of debt as a cheaper source of financing are offset by the rise in cost of equity, resulting in no change in the firm’s WACC. (schweser book 2 pg 277).
Thanks alot, makes much mroe sense now.