Question

Blue Bull, Inc., has a target debt-equity ratio of .82. Its WACC is 8.6 percent, and the tax rate is 30 percent.

(a) If the company’s cost of equity is 12.2 percent, what is its pretax cost of debt?

(b) If the aftertax cost of debt is 5.3 percent, what is the cost of equity?

Answer 1

	WACC = Pretax cost of debt[rd]*Weight of debt[wd]+Cost of equity[rs]*Weight of equity[ws]
	As debt equity ratio is 0.82, Equity will be 1.
	Weight of debt=0.82/1.82 and weight of equity = 1/1.82.
	Substituting available values, we have
a)	8.6 = rd*0.82/1.82+12.2*1/1.82
	rd = (8.6-12.2*1/1.82)*1.82/0.82 = 4.21%
	CHECK:
	WACC = 4.21*0.82/1.82+12.2*1/1.82 = 8.60%
	rd = Post-tax cost of debt
	Pre-tax cost of debt = rd/(1-30%) = 4.21/70% = 6.01%
B)	8.6 = 5.3*0.82/1.82+rs*1/1.82
	rs = (8.6-5.3*0.82/1.82)*1.82/1 = 11.30%
	CHECK:
	WACC = 5.30*0.82/1.82+11.30*1/1.82 = 8.60%