Easy Corp Finance question (R 26, P 3)

CFA Level II Corporate Finance
#1

In question 3 of reading 26, you are asked to find the cost of equity (WACC = 10%, CoD = 5%, MTR = 20%, cap structure = 50% debt 50% equity.

Using the equation re = r0 + (r0 - rD)(1-t)(D/E) -> = 10% + (10% - 5%)(80%)(1) I find 14%. The answer is 16%. What am I doing wrong?

#2

re = r0 + (r0 - rD)(1-t)(D/E)

should change to

re = r0 + (r0 - rD*(1-t))(D/E)

only rd is multiplied by (1-t) not the whole thing

so 10 + (10-5*0.8)*1 = 10 + 6 = 16

#3

Thank you! However the equation for re is incorrect on page 104, ex 2 then.

And in question 10’s solution, the formula I gave is used…

#4

there should be errata for that

#5

It’s not listed in the errata, and the equation is used in the solution to question 10.

Elan also gives the equation as shown in CFAI…this is strange.

#6

10% = 50% (Required return for Equity) + 50% (1-20%) (5%)

solve for Required return of Equity = 16%

#7

Oh I feel silly now. I thought r0 = rWACC, but it is specifically the cost of capital for an all- equity company.

Using the WACC formula: rWACC = (D/V)rd(1-t)+(E/V)re and solving for re gives the correct answer. re = [rWACC - (D/V)rd(1-t)] / (E/V) = [10% - 50%*5%*(1-20%)]/50% = 16%. Thanks to those who responded.