Question

Blitz Industries has a debt-equity ratio of .7. Its WACC is 8.9 percent, and its cost of debt is 6.2 percent. The corporate tax rate is 21 percent.

  

a.	What is the company’s cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b.	What is the company’s unlevered cost of equity capital? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-1.	What would the cost of equity be if the debt-equity ratio were 2? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-2.	What would the cost of equity be if the debt-equity ratio were 1.0? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c-3.	What would the cost of equity be if the debt-equity ratio were zero? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

(a) Debt-to-Equity Ratio = DE = 0.7, WACC = 8.9 %, Cost of Debt = 6.2 % = kd and Corporate Tax Rate = T = 21 %

Let the cost of equity be ke

Therefore, WACC = ke x (E/V) + kd x (1-T) x (D/V) = ke x (1/1.7) + 6,2 x (1-0.21) x (0.7/1.7) = 8.9

ke x (1/1.7) = 6.8832

ke = 6.8832 x 1.7 = 11.7014 %

(b) Let the unlevered cost of equity be Ru

Therefore, 11.7014 = Ru + DE x (1-T) x (Ru - 6.2)

11.7014 = Ru + 0.7 x (1-0.21) x (Ru - 6.2) = Ru + 0.553 Ru - 3.4286

1.553 Ru = 15.13

Ru = 15.13 / 1.553 ~ 9.74 %

(c1) If debt to equity ratio is 2 and let the cost of equity be r1

Therefore, r1 = 9.74 + (1-0.21) x 2 x (9.74 - 6.2) = 15.33 %

(c2) If debt to equity ratio is 1 and let the cost of equity be r2

Therefore, r2 = 9.74 + (1-0.21) x 1 x (9.74 - 6.2) = 12.54 %

(c3) If debt to equity ratio is 0 and let the cost of equity be r3

Therefore, r3 = 9.74 + (1-0.21) x 0 x (9.74 - 6.2) = 9.74 %