Question

Kelso Corp. has a cost of debt of 5% and a tax rate of 34%. Its weight on debt is 25% and its weight on equity is 75%. Its WACC is 8.325%. Which of the following is the only possible return on the unlevered firm (rU)?

Answer 1

WACC = 8.325%

Weight of debt (WD) = 25%

Weight of equity (WE) = 75%

cost of debt (Kd) = 5%

Tax rate (T) = 34%

WACC = rU(WE) + rD(WD)(1-T)

8.325 = rU(0.75) + 5(0.25)(1-0.34)

8.325 = 075rU + 0.825

8.325 - 0.825 = 0.75rU

7.50 = 0.75rU

7.50 = rU

0.75

rU = 10%

The return on unlevered firm (rD) is 10%

Step-by-step explanation:

In this case, there is need to apply WACC formula. WACC, cost of debt, weight of debt and weight of equity were given with the exception of return on equity(rU). Therefore, return on equity becomes the subject of the formula. The return on equity represents the return on unlevered firm.