MM with Taxes Williamson, Inc., has a debt-equity ratio of...

MM with Taxes Williamson, Inc., has a debt-equity ratio of 2.5. The firm's weighted average cost of capital is 10 percent, and its pretax cost of debt is 6 percent. Williamson is subject to a corporate tax rate of 35 percent. a. What is Williamson's cost of equity capital? b. What is Williamson's unlevered cost of equity capital? c. What would Williamson's weighted average cost of capital be if the firm's debtequity ratio were .75 ? What if it were 1.5 ?

MM with Taxes Williamson, Inc., has a debt-equity ratio of 2.5. The firm's weighted average cost of capital is 10 percent, and its pretax cost of debt is 6 percent. Williamson is subject to a corporate tax rate of 35 percent.
a. What is Williamson's cost of equity capital?
b. What is Williamson's unlevered cost of equity capital?
c. What would Williamson's weighted average cost of capital be if the firm's debtequity ratio were .75 ? What if it were 1.5 ?

Key Concepts

Debt-Equity Ratio

The debt-equity ratio is a measure of a company's financial leverage, calculated by dividing its total debt by its total equity. This ratio is crucial in understanding the firm's capital structure and the extent to which debt is used to finance operations. It also influences the cost of equity through its impact on financial risk, as higher leverage typically leads to a higher cost of equity.

Unlevered Cost of Equity

The unlevered cost of equity, or asset return, represents the return required by investors assuming the firm is entirely financed by equity. It removes the impacts of leverage on the equity risk, providing a baseline measure of the firm's riskiness that is independent of its capital structure.

Weighted Average Cost of Capital (WACC)

WACC is the average rate of return a company is expected to pay its security holders to finance its assets. It accounts for the relative costs of debt and equity financing, weighted by their proportions in the firm's capital structure. When taxes are considered, the tax deductibility of interest expenses lowers the effective cost of debt, thereby reducing the WACC.

Cost of Equity Capital

The cost of equity capital is the return that equity investors require for investing in a company. It reflects the compensation investors demand for taking on the higher risk associated with equity investments compared to debt. In leveraged firms, the cost of equity increases with additional debt due to the higher risk borne by equity holders.

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