Use the information for the question(s)below.
KT Enterprises is considering undertaking a new project.Based upon analysis of firms with similar projects,KT has determined that an unlevered cost of equity of 12% is suitable for their project.KT's corporate tax rate is 21%,its borrowing rate is 7%,and KT does not believe that its borrowing rate will change if the new project is accepted.
-If KT expects to maintain a debt to equity ratio for this project of .6 then KT's equity cost of capital,rE,for this project is closest to:
A)5.0%.
B)12%.
C)15.0%.
D)17.0%.

Question

Quizplus · Accepted Answer

The formula for the weighted average cost of capital (WACC) is:
WACC = E/V * rE + D/V * rD * (1 - T)
where:
E = market value of equity
D = market value of debt
V = total value of the firm (V = E + D)
rE = cost of equity
rD = cost of debt
T = corporate tax rate

To find the equity cost of capital (rE), we need to rearrange the WACC formula and solve for rE:

rE = (WACC - D/V * rD * (1 - T)) * V/E
where:
WACC = unlevered cost of equity + (1 - tax rate) * cost of debt * debt/equity
D/V = debt to value ratio
rD = borrowing rate
T = corporate tax rate

Substituting the given values:
unlevered cost of equity = 12%
tax rate = 21%
borrowing rate = 7%
debt to equity ratio = 0.6

WACC = 0.12 + (1 - 0.21) * 0.07 * 0.6/0.4 = 0.1074

D/V = 0.6/1.6 = 0.375
V/E = 1/0.4 = 2.5

rE = (0.1074 - 0.375 * 0.07 * (1 - 0.21)) * 2.5 = 0.15 or 15%

Use the Information for the Question(s)below