Jungle, Inc. has a target debt-equity ratio of 0.72. Its WACC is 11.5 percent and the tax rate is 34 percent. What is the cost of equity if the aftertax cost of debt is 5.5 percent?
To find the cost of equity, we need to use the WACC formula which is a weighted average of the cost of debt and the cost of equity. Here are the steps to calculate the cost of equity:
Step 1: Determine the weight of debt and equity in Jungle, Inc.'s capital structure.
Since the target debt-equity ratio is given as 0.72, we can calculate the weights as follows:
Weight of Debt = 0.72
Weight of Equity = 1 - Weight of Debt = 1 - 0.72 = 0.28
Step 2: Calculate the after-tax cost of debt.
The after-tax cost of debt is given as 5.5 percent. Since the tax rate is 34 percent, we can calculate the before-tax cost of debt as follows:
Before-tax cost of debt = After-tax cost of debt / (1 - Tax rate) = 5.5% / (1 - 0.34) = 5.5% / 0.66 ≈ 8.33%
Step 3: Calculate the cost of equity using the WACC formula.
WACC formula: WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt)
We know the following:
WACC = 11.5%
Weight of Debt = 0.72
Weight of Equity = 0.28
Cost of Debt = 8.33%
Now we can substitute the values into the formula to solve for the Cost of Equity:
0.115 = (0.28 * Cost of Equity) + (0.72 * 8.33%)
0.115 = 0.28 * Cost of Equity + 5.9976%
Rearranging the equation, we get:
0.115 - 5.9976% = 0.28 * Cost of Equity
-5.8826% = 0.28 * Cost of Equity
Divide both sides by 0.28 to solve for Cost of Equity:
Cost of Equity = -5.8826% / 0.28 ≈ -21.0093%
Therefore, the Cost of Equity for Jungle, Inc. is approximately -21.0093%.