Arrow Corp.has a WACC of 8.78%,a before-tax cost of debt of 6%,and a tax rate of 40%.If the firm is financed 30% with debt and the balance with equity,what is the cost of equity?

Question

Quizplus · Accepted Answer

Using the formula for weighted average cost of capital (WACC):

WACC = (E/V) x Re + (D/V) x Rd x (1 - T)

Where:

E = market value of the firm's equity
D = market value of the firm's debt
V = E + D = total market value of the firm's financing
Re = cost of equity
Rd = cost of debt
T = tax rate

We can solve for Re:

Re = (WACC - (D/V) x Rd x (1 - T)) / (E/V)

Substituting the given values:

WACC = 8.78%
Rd = 6%
T = 40%
D/V = 30%
E/V = 70%

Re = (8.78% - (0.30 x 6% x (1 - 0.40))) / 0.70
Re = 11.00%

Therefore, the cost of equity for Arrow Corp. is 11.00%.